0:13
In this module we're going to look at one of
the most important pillars of classical economics known as Say's Law.
It's a simplistically seductive idea that,
at least a Keynesian economists,
turns out typically to be wrong.
Say's Law was formulated in the 1800s by French businessman,
Jean-Baptiste Say and it was
popularized by the British political economist, David Ricardo.
In this key definition,
Say's Law says quite simply that,
supply creates its own demand.
Let me repeat that because it sounds so seductively simple and true.
According to Say's Law,
supply creates its own demand,
and the importance of Say's law is that
an economy's own production will be the source of its own demand.
Here's the Say's Law argument.
People work to produce goods and services and thereby create supply in an economy.
For their work, they earn income and as a key assumption of the Say's Law argument,
this income is assumed to equal the total value of the goods and services produced.
Now, it follows from this assumption that if workers spend all of the income they earn,
it must be enough to pay for all the goods and services they produce.
Therefore, according to Say's Law,
supply must indeed create its own demand.
Or, in the parlance of macroeconomics,
there must be enough aggregate demand for the available aggregate supply.
That does indeed sound quite logical.
It is an argument that also has
important policy implications because it clearly implies that the economy will
always find an equilibrium between
whatever aggregate supply it produces and aggregate demand.
But what could go wrong with the Say's Law argument?
Take a minute now as we pause the presentation to think about this,
and perhaps jot down a few reasons why supply might not always create its own demand.
As you do so, study this figure carefully for clues
of any potential problems.
Ok, that was a hard question.
Let's look at the standard critique of Say's Law.
Suppose then that income earners don't spend
all their money and instead save some of them.
That's exactly the problem that Thomas Malthus raised in this critique of Say's Law.
By the way, you've probably heard of Thomas Malthus before.
He's famous not for his critique of Say's Law,
but rather for the Malthusian Doctrine that says,
population will grow faster than production of
food and this will lead to mass starvation.
In fact, it was Malthus's dark vision of
an overpopulated and starving world that originally
earned the economics profession its label as the Dismal Science.
As for his critique of Say's Law,
Thomas Malthus said this,
if people don't spend all of their money,
there will be a general glut of goods,
this will in turn,
lead the people being out of work,
and therefore create not demand but rather unemployment.
And that sounds pretty logical too.
So how do you think Jean-Baptiste Say and David Ricardo responded?
Take a minute now to jot down some ideas.
Ok, here's what Jean-Baptiste Say and David Ricardo said in response to Malthus.
Doesn't matter if people save some of their money because all of these savings will in
turn be invested in the economy and there will be no unemployment problem.
In other words, in this reformulation of Say's Law,
aggregate demand which equals consumption plus investment,
will still always equal aggregate supply and there
will be no unemployment.
5:07
Take a look now at this figure,
to follow the logic of Say's Law.
This is an important diagram in macroeconomics known as the circular flow diagram,
the circular flow diagram.
You can see in this circular flow diagram that the employee compensation paid to workers,
the rents paid to landowners,
the interest paid to money lenders,
and the profit earned by business owners,
together represent the total income earned by all the people producing aggregate supply.
This flow of income moves from right to left at the top of
the figure from business firms to households,
and it represents aggregate supply in Say's Law.
Now on the demand side,
you should also see several arrows at the bottom of the diagram.
One arrow moves from left to right,
and it represents consumer purchases of goods and services from businesses.
A second arrow shows consumer savings moving first into the banking and finance sector,
and then emerging as investment by business.
Together, consumption plus investment equals aggregate demand in Say's Law.
Take a minute now to study this diagram before we move on to the next module,
and the quantity theory of money.
That's the second pillar of classical economics.