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2.4 Say’s Law

In 1803, Jean-Baptiste Say’s Treatise of Political Economy was published.

The simplest version of the law associated with this economist is that labour

will only offer itself for employment in order to obtain income which is then

used to purchase the output produced. In his own words, Say puts forward the

proposition in the following way.

A product is no sooner created, than it, from that instant, affords a market for

other products to the full extent of its own value … the mere circumstance of the

creation of one product immediately opens a vent for other products. (Say, 1821)

In other words, because the act of production simultaneously creates income

and purchasing power, there could be no impediment to full employment

caused by a deficiency of aggregate demand. The dictum ‘supply creates its

own demand’ captures the essence of Say’s Law, which aimed to characterize

the essential feature of exchange within a specialized economy. That the act

of supply created an equivalent demand seemed obvious to the classical

writers. The law does not deny the possibility that a misallocation of resources

can occur and that a glut of certain commodities can develop, but this

problem would be temporary and no such excess supply could occur for

goods as a whole. For more detailed and sophisticated discussions of Say’s

contribution, see Sowell (1972); Baumol (1977, 1999); and Backhouse (2002).

Say’s Law was originally set forth in the context of a barter economy

where, by definition, the act of supplying one good unavoidably implies the

demand for some other good. In general, classical economists, notably Ricardo

and Mill, gave support to Say’s Law, which they believed also held true for a

monetary exchange economy. Money was nothing more than a convenient

medium of exchange which enabled market participants to avoid the awkwardness

and inconvenience of barter. If Say’s Law applies to a money-using

economy, then the implication is that a market is guaranteed for whatever

level of output is produced, although market forces will obviously lead to

changes in the composition of aggregate output. If aggregate demand and

aggregate supply are always guaranteed equality, then money is nothing more

than a ‘veil’ covering the underlying real forces in the economy.

At this point it is important to distinguish between two versions of Say’s

Law. According to Trevithick (1992) the weak version is taken to imply that

each act of production and supply necessarily involves the creation of an

equivalent demand for output in general. But this version of Say’s Law does

not guarantee that the output produced will be consistent with full employment.

It merely states that whatever level of aggregate output happens to be

forthcoming will find a market. This weak version of Say’s Law applies to

both depressed and buoyant levels of output. The strong version of Say’s Law

states that in a competitive market economy there will be an automatic

tendency for full employment to be established (see panel (b) of Figure 2.2).

Since the strong version of Say’s Law implies an equality of aggregate

demand and supply which is consistent with labour market equilibrium, it is

equivalent to the proposition that there is no obstacle to the achievement of

full employment in terms of a deficiency of aggregate demand. To see how

the classical economists justified their belief that aggregate spending in the

economy will always be sufficient to purchase the full employment level of

output, we need to examine their ideas relating to investment, saving and the

rate of interest.

The classical theory of interest rate determination plays a crucial role in

ensuring that a deficiency of aggregate demand does not occur. If we imagine

an economy consisting of two sectors, firms and households, we can write

down the following equation, which tells us that in equilibrium aggregate

expenditure (E) must equal aggregate output (Y).

E C(r) I(r) Y (2.10)

Furthermore, aggregate expenditure consists of two components: investment

expenditure (I) which arises from firms and consumption expenditure (C)

which arises from households. The planned demand for goods (E) is the sum

of the planned demand for consumption goods plus the planned demand for

investment goods. In the classical model the demand for both types of goods

is a function of the interest rate (r). Since households do not automatically

spend all of their income, we can also write down equation (2.11):

Y −C(r) S(r) (2.11)

Combining (2.10) and (2.11) yields the equilibrium condition given by (2.12):

S(r) I(r) (2.12)

We can see from (2.11) that in the classical model saving (S) is also a

function of the interest rate. The higher the rate of interest the more willing

will savers be to replace present consumption with future consumption. Hence

the classical economists viewed the interest rate as a real reward for abstinence

or thrift. The flow of saving therefore represents a supply of loanable

funds in the capital market. Since household saving responds positively to the

rate of interest (S/r > 0), household consumption must be negatively

related to the rate of interest (C/r < 0). Investment expenditure on capital

goods is negatively related to the rate of interest in the classical model (I/r

< 0) and represents a demand for loanable funds in the capital market.

Investment spending by firms can only be justified if the expected rate of

return from the expenditure is greater than, or at least equal to, the cost of

acquiring the funds used to purchase the capital goods. The higher the rate of

interest, the higher the explicit (and implicit) cost of the funds used to

purchase the capital goods. We can therefore represent business expenditure

(I) as a declining function of the interest rate. The relationship between

investment, saving and the interest rate in the classical model is shown in

panel (a) of Figure 2.3. The twin forces of productivity and thrift determine

the real rate of interest, and variations in the interest rate act as an equilibrating

force which maintains equality between the demand for and supply of

loanable funds, ensuring that aggregate demand is never deficient. By referring

to Figure 2.3 we can see how important flexibility in the interest rate was

to the classical equilibration process. In panel (a) we represent the classical

theory of interest rate determination, with the interest rate on the vertical axis

Figure 2.3 The classical interest rate mechanism and Say’s Law

and the flows of saving and investment measured on the horizontal axis. In

panel (b) real output is measured on the vertical axis with the overall demand

for commodities (C + I) measured on the horizontal axis. From Figure 2.2 we

know that competition in the labour market will yield an equilibrium real

wage and level of employment which, when combined with the production

function, give a level of full employment output of Ye. Panel (b) of Figure 2.3

indicates that aggregate expenditures of an amount equal to E0 are necessary

to purchase the output of Ye. Since output and demand are identical at all

points along the 45° line, any point such as B and C is consistent with the

weak version of Say’s Law. Point A in panel (b) corresponds to the strong

version of Say’s Law. Not only are aggregate expenditure and output in

equality, Ye corresponds to the level of output associated with full employment

labour market equilibrium.

We can best see the importance of interest rate flexibility in this model by

asking what would happen if households suddenly decided to save more

(consume less). This is represented in panel (a) of Figure 2.3 by a rightward

shift of the saving function from S0 to S1. The initial excess supply of loanable

funds would lead to a fall in the rate of interest from r0 to r1. This would

encourage an increase in investment expenditure from I0 to I1. Since E0 – I0

equals consumption expenditure, it is clear that the rise in investment expenditure,

I1 – I0, exactly offsets the fall in consumption expenditure equal to

C in the diagram. Aggregate expenditure would remain at E0, although its

composition would change.

Even though in the classical model the decisions to save and invest can be

carried out by different sets of people, the rate of interest will change so as to

reconcile the desires to save and invest. In Keynesian theory divergences

between S and I cause a quantity response. In the case of an increase in

saving, the Keynesian model predicts a decline in aggregate spending, output

and employment; that is, Keynes’s paradox of thrift. The classical model,

armed with Say’s Law, flexible wages, prices and the interest rate, can experience

changes in the structure of final demand but no prolonged demand

deficiency and involuntary unemployment. A remarkable result.

Not all the classical economists accepted Say’s Law and its implications.

Robert Thomas Malthus argued that a general glut of commodities was

possible. Whereas Ricardo, Mill and the followers of Say believed that the

conditions of supply determine aggregate output, Malthus, anticipating Keynes,

gave emphasis to demand as the determining factor (see Dorfman, 1989). But

‘Ricardo conquered England as completely as the Holy Inquisition conquered

Spain’ (Keynes, 1936, p. 32). For Keynes the completeness of the

Ricardian victory was something of a curiosity and a mystery. For this reason

he gave high praise to Malthus for anticipating his own ideas with respect to a

general deficiency of aggregate demand (see Keynes, 1936, pp. 362–71).

Although Ricardo appeared to be stone deaf to what Malthus was saying, part

of the disagreement had its origin in the time horizon adopted by each writer.

Ricardo had his eyes fixed firmly on the long run, whereas Malthus, like

Keynes, was more concerned with the short run.

In our discussion of the classical model so far we have concentrated on the

real sector. The operation of the labour and capital markets, buttressed by

Say’s Law, provided the classical economists with a theoretical system capable

of explaining the determination of the real variables in the system. But

what determines the price level in the classical model? The final component

that explains the determination of the price level and the other nominal values

in the classical economists’ system is the quantity theory of money.