Aggregate Demand–II

by Russ Roberts on October 28, 2011

in State of Macro

Karl Smith has responded to my post on aggregate demand. He has a lot to say, but I think the nub of it is right at the beginning:

First, like ordinary demand, Aggregate Demand is not a quantity but a relation. It matches the total amount of goods and services people want to buy with the price level. So, saying Aggregate Demand has increased, in-and-of-itself doesn’t say anything about the volume of transactions in the economy. That depends on the equilibrium between Aggregate Demand and Aggregate Supply.

I understand what Karl calls “ordinary demand.” You want to buy less of a good when it gets more expensive, more of it when it gets cheaper. Suppliers tend to have the opposite behavior. They want to sell more of it when it’s more expensive and less of it when it’s cheaper. When you aggregate across all buyers in a market, you get the market demand curve. Do the same across all sellers you get the market supply curve. Each of these is well-defined as the horizontal sum of the individual curves. I say, well defined, but in fact, they don’t really exist. They are concepts that help us organize our thinking about how prices get determined, how much of a good will be bought and sold, and market forces that move prices and quantities.

But what are aggregate demand and aggregate supply for an economy? Karl writes that aggregate demand “matches the total amount of goods and services people want to buy with the price level.” I’m not sure what he means by matches. I think he just means the relationship between goods and services and prices. But what does it mean to say that when the price level of all goods goes up, people want to buy less stuff? What’s the behavioral assumption? Is there a budget constraint? Is it meaningful to talk about aggregate demand at all, as if all the goods could be aggregated into a single good with a single price? Are people spending all their money?

And when you add in aggregate supply, that where it crosses with aggregate demand, does where they cross on the vertical axis determine the price level? That would be weird. Where’s monetary policy?

I was really good at IS-LM when I was an undergrad. Fortunately, as you can tell from the above, I have forgotten all of it. So I’m starting from scratch looking at what makes sense. What am I missing Karl?

At the end, Karl asks if I think money can be non-neutral in the short-run. Non-neutral means–can have real effects on the economy and the choices people make rather than just affecting the price level. Sure. I have no problem with that. Looking forward to Karl’s response.

 

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