INCOME-EXPENDITURE MODEL: A macroeconomic model, which captures the essence of Keynesian economics, is based on the equality between total income generated from gross domestic product and total expenditures on gross domestic product. The cornerstone of the income-expenditure model is the consumption function, which relates household consumption expenditures to income and gives rise to the aggregate expenditure line with the addition of investment, government purchases, and net exports. The intersection between the aggregate expenditure line at the 45-degree identifies equilibrium.
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A principle of classical economics developed the French economist Jean-Baptiste Say that is commonly summarized as "supply creates its own demand." This law, also referred to as Say's "theory of markets" or "law of markets," indicates that the act of producing aggregate output generates a sufficient amount of aggregate income to purchase all of the output produced. This principle indicated that excess production or insufficient demand for production was unlikely to occur, at least for any extended period. When combined with flexible prices and saving-investment equality, Say's law further implied that an economy would achieve and maintain full employment of resources. This law was singled out by John Maynard Keynes in his critique of classical economics, but remains relevant in current macroeconomic analysis, reflected in the circular flow model. Say's law that "supply creates its own demand" is one of the fundamental principles of classical economics. This principle is attributed to the noted French classical economists, Jean-Baptiste Say, although it was simultaneously advocated by several economists of the day. The law is often misinterpreted to mean any firm that produces a good is guaranteed profitable sales. It more correctly means that the act of production generates enough income for an equivalent amount of demand for other production. When applied to the macroeconomy, Say's law indicates that economic downturns cannot be caused by the lack of demand, that is, overproduction. The aggregate production of output generates just enough income to equate aggregate demand with aggregate supply.
Jean-Baptiste SaySay's law was named after Jean-Baptiste Say, a French economist who helped to popularize the work of Adam Smith in the early 1800s. While Say was something of a disciple of Smith, promoting free markets, individual choice, competition, and other Smithian notions, he also make his own contributions to the development of classical economics.
One notable contribution was the division of resources into the four primary categories of labor, capital, land, and entrepreneurship. In particular, he stressed the importance of entrepreneurship as a factor of production. Another contribution was the observation that value (or the price of a good) depends on both the cost of production and the satisfaction (or utility) generated from consumption. Say also identified some of the basic notions of money that are standard textbook topics, include the characteristics of money, double coincidence of wants, and the natural evolution of commodity money.
Of course, at the top of the list of contributions is his theory of markets--Say's law. Actually, Say was only one of several classical economists who put forth the basic argument that "supply creates its own demand." Whether or not he was the first is not readily known, but as a major proponent, it bears his name.
A Theory of MarketsSay never actually identified the notion of production generating spendable income as "Say's law." The naming of this principle is largely attributed to John Maynard Keynes, who developed the counter notion of "effective demand" within the context of his Keynesian economic theory. Say referred to this principle as the "theory of markets" or the "law of markets."
A essential feature of Say's theory of markets was the interdependence of market activity, that is, the demand for one good is dependent on the production of another good. The income generated from the production of one good, such as OmniMotors XL GT Sports Coupes, generates the income that is used by consumers to purchase other goods, such as Hot Momma Fudge Bananarama Ice Cream Sundaes or Wacky Willy Stuffed Amigos.
Say's theory of markets directed attention to the supply or production side of the economy (compared with later Keynesian economics that focused on the demand or consumption side). Say contended that macroeconomic activity began with production--without production there was no consumption. Moreover, his famous law of markets indicated that aggregate production generates sufficient aggregate demand to purchase all available output.
However, Say's law of markets DID NOT mean that all markets would be in balance at all times. Some markets could have surpluses and others could have shortages. In aggregate, though, the surpluses and shortages balanced out giving an overall balance of aggregate production and aggregate demand.
Moreover, Say's law of markets DID NOT indicate that an economic downturn (that is, business-cycle contraction) was impossible. His law merely placed the cause of any downturn on the supply side of the economy, not the demand side. According to Say, a recession was not due to the lack of demand and the overproduction of goods (a primary contention of Keynesian economics). Instead, such problems were attributable to money.
The Circular Flow
Although criticism by John Maynard Keynes and the prolonged economic downturn of the 1930s Great Depression went a long way to discredit Say's law, it continues to play a role in modern economic analysis. This is due, in part, to a group of "new classical" economists who have renewed the basic principles of classical economics. Their work has surfaced in rational expectations theory, supply-side economics, and the long-run AS-AD analysis.
While debate continues over the validity of these theories, as well as the relative importance of aggregate supply (stressed by new classical economists) versus aggregate demand (emphasized by Keynesian economists), Say's law of markets is revealed in the less controversial circular flow model.
The exhibit to the right presents the basic circular flow model of economic activity. To the far right of the exhibit is the business sector and to the far left is the household sector. At the top of the exhibit are the product markets and at the bottom of the exhibit are the resource markets. The business sector buys the services of resources through the resource markets from the household sector, which it uses to produce the output (gross domestic product) that is sold to household sector through the product markets.
The income (national income) that the household sector uses to purchase production is generated by factor payments to resource owners by the business sector. If the business sector produces no output, then the household sector has no income to spend on consumption. This relation captures the essence of Say's law. More production by the business sector means more factor payments to the household sector and more income that can be spent on consumption.
A Keynesian CritiqueKeynesian economics was developed by John Maynard Keynes in 1936 during the depths of the Great Depression. Keynes promoted his new theory of macroeconomics it part by showing where the existing classical economics went wrong, especially why it was unable to explain the length and severity of the Great Depression. Keynes was most critical of Say's law.
Keynes questioned whether or not supply does in fact create demand. While, in principle, revenue generated by production ultimately ends up as household income, this does not happen instantaneously. In the meantime, households can only spend the income that they actually have. If they have less income, then they spend less, less is sold, less is produced, and less revenue is generated.
SAY'S LAW, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 24, 2024].
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