The four greatest neoclassical economic philosophers: from top left clockwise,
Adam Smith (Wikimedia Commons / Scottish National Gallery),
J.B.Say  (Wikimedia Commons),
Carl Menger (Wikimedia Commons / Mises.org) , 
and David Ricardo(Wikimedia Commons  /  National Portrait Gallery).

After my last post,  Say’s Law Vs. Keynes’ Law: At the Heart of the Argument, a reader left the following comment.

I think it’s silly to call something a law which is far from universally true, which both of these things are (far from universally true)… while I don’t see any Keynesians claiming what you’ve called Keyne’s law to be a law, I do see conservatives defending Say’s generalization as a “law”. Why the pretension of “law” at all?

Is Say’s Law or Keynes’ Law Universally True?

This comment brings up several issues. The first of these is whether or not Say’s Law or Keynes’ Law is universally true in some sense. The second issue is whether or not Keynesians actually claim Keynes’ law to be an objective law of economic reality. Finally, what do we mean by an economic law anyway?

Let us dispose of the second issue first. It is not common to see the term “Keynes Law”, but it is occasionally used as the inverse of Say’s Law. As examples, look at the posts Keynes’ Law and Say’s Law in the AD/AS Model and Which Is More Accurate, Say’s Law or Keynes’ Law?. To be fair, the author of the second post, economist and economic historian Mark Skousen, is a neoclassical economist himself and not a Keynesian. Expressed as inverses of each other, the two statements are:

• Say’s Law: Supply creates Demand
• Keynes’ Law: Demand creates Supply

As you probably appreciate, such short summaries do little justice to the supporting ideas of each supposed law. The ideas supporting Keynes’ law are expressed in a graphical model called the Aggregate Demand/ Aggregate Supply (AD/AS) model. To understand it, you must understand what the general price level  is. The general price level is a measure over some period of time (daily, quarterly, or annually) of overall prices for some set of of goods and  services (the so-called consumer or market basket) normalized relative to a base set. Let N be the number of goods and services in the market basket, q_0,c be the quantity of good c sold during the base period, and p_0,c be the price of good c in the base period. Then the normalizing constant is given by

Q₀ = q_0,1·p_0,1 + q_0,2·p_0,2 + . . . + q_0,N·p_0,N 

which can be taken as the total value of goods in the basket sold in the base time period. Next, we calculate the same quantity in a different time period t, when the prices are p_t,c, but using the same quantities of goods as during the base year. Then,

Q_t = q_0,1·p_t,1 + q_0,2·p_t,2 + . . . + q_0,N·p_t,N 

is the total value at time t of the same goods and the same quantities as were bought during the base period. The general price level during period t is defined by

P_t = Q_t / Q₀.

If market prices generally rise, P_t will increase, and consumers and companies will generally buy less. Aggregate demand (i.e. demand from all consumers, including businesses and government) will decrease with increasing price level. Similarly, as price levels increase, companies are willing to produce more and aggregate supply (the monetary value of all goods produced) will increase.

Price levels such as this play a central role in measuring inflation. The Consumer Price Index (CPI) is a price level of this nature. They also play an important role as the vertical axis of an AD/AS model, as shown below. The AD/AS model represents some of the core beliefs of Keynesians from the days of John Maynard Keynes to the present, as well as some newer Keynesian ideas about what happens with changing price levels.

You can think of this plot as an aggregate version for the entire economy of single good supply and demand curves, where the real GDP takes the place of the quantity of the good sold or bought, and the price level plays the role of the good’s price. The curve labeled SRAS is the short-run aggregate supply curve, while the three curves labeled AD_k, AD_i, and AD_n are the aggregate demand curves for three different economic situations. In this context, “short-run” means a period of time short enough that the price level does not change. The AD curves denote total goods and services consumers would be willing to buy at different price levels, which must be equal to the real GDP in economic equilibrium. Note that as the price level declines, the real GDP on any given aggregate demand curve increases. This means as the economy becomes less inflationary, everyone is willing to buy more goods in constant dollars. Note also that as the price level becomes more inflationary, the real GDP that producers are willing to supply increases, as indicated by the SRAS curve. Where the current aggregate demand curve intersects the short-run aggregate supply curve is a point of short-run equilibrium, where aggregate supply equals aggregate demand.

Finally, notice the plot is divided into three regions:

• The Keynesian zone with P < P_i and Y< Y_i
• The intermediate zone with P_i < P < P_n and Y_i < Y < Y_n
• The neoclassical zone with P_n < P and Y_n < Y

In the Keynesian zone the aggregate supply curve is close to horizontal, the GDP is way below the potential GDP point of Y_n, unemployment is high because of the low GDP, and inflation is very low. Because changes in the price level are relatively low for any particular shift in GDP, Keynesians advocate stimulating growth in GDP through either increased government spending or a looser monetary policy. Because there is now additional government demand added to existing demand, the entire aggregate demand curve shifts to the right with an increase of GDP at the cost of a very small increase in inflation.

In the intermediate zone, the short-run aggregate supply curve ceases to be fundamentally horizontal, meaning the same dose of Keynesian stimulus will achieve   aggregate demand shifts giving smaller increases in GDP in return for larger increases in the price level and therefore of inflation. In the neoclassical zone the short-run aggregate supply curve becomes almost vertical and is asymptotic to the long-run aggregate supply (LRAS), which is a vertical line at Y=Y_n, the potential GDP. [Note the error in the figure above. LRAS should be to the right of SRAS with SRAS asymptotic to it. If SRAS truly did cross the LRAS line, market forces caused by growing surpluses would immediately reduce output and pull aggregate supply back to LRAS.] In the neoclassical zone, the neoclassical economic picture provides a perfect portrait of the economy, and increasing demand can no longer increase GDP. In fact increasing demand is no longer possible since it cannot be matched by supply. The only possible way to increase GDP at this point is to increase the economy’s capacity to produce by increasing total factor productivity through investment. This would result in a shift of the SRAS and LRAS curves to the right, with a higher value of GDP at the equilibrium point.

Therefore, in the Keynesian version of economic reality, which law relates supply to demand, Say’s Law or Keynes’ Law, depends on where the economy finds itself in the AD/AS model. If the economy is near an equilibrium point that is in the Keynesian zone, then clearly Keynes’ law is operative, since shifting the demand curve to the right causes increasing GDP at the new equilibrium point of intersection with SRAS. If the economy is in the neoclassical zone, then Say’s Law is operative since increasing supply pushes LRAS and SRAS to the right.

That is from the Keynesian point of view. Looking at all this from a neoclassical vantage, an economist would exclaim, “Stuff and nonsense! Very elaborate stuff and nonsense, but stuff and nonsense nevertheless!” For one thing, this Keynesian model assumes no shifting of the short-run aggregate supply curve while the aggregate demand curve is shifting rightwards. It assumes suppliers will be slow in reducing the price level to sell off their inventories, after which the only way to  satisfy increasing demand would be to increase supply. Also, it neglects the phenomenon of decreasing consumer and corporate demand at the same time as government demand is increasing. As I have noted elsewhere, large government stimulus programs have a strong tendency to allocate capital in many ways different from what the economy actually needs. This would decrease both consumer and corporate demand. In addition, such a misallocation of capital would actually move both SRAS and LRAS to the left, putting the aggregate demand curve closer to the neoclassical zone. In the end, businesses can be expected in hard economic times to cut their losses by selling their inventories before producing much more, thereby shifting the aggregate supply curves to the left. The only reliable way to increase GDP in all the zones of the AD/AS model is to increase aggregate supply, which increases aggregate demand by the money firms pay to their suppliers and as wages and salaries to their workers.

No matter how you cut it, producers must produce before consumers can consume.

From this neoclassical point of view, Keynes’ Law has very limited applicability, restricted to a Keynesian zone shrunk both by businesses clearing their inventories and by the effects of capital misallocations by Keynesian stimulus. At the same time Say’s Law has a universal effect over all the AD/AS zones by shifting both SRAS and LRAS to the right. Jean-Baptiste Say beats John Maynard Keynes in all cases.

What Can We Mean by an “Economic Law”?

So how can I react to the comment at the very top of this post? I would agree with the commenter that the limited applicability of Keynes’ Law makes it very silly to think of it as a law at all. However, Say’s law does appear to be universally relevant under all economic conditions, justifying its designation as an economic law.

Perhaps one concern about using the term “law” in connection with economics is that this discipline is as much a study of mass psychology as anything else, And how universally predictable can human psychology be? On the level of the individual human being, probably not very predictable at all. This is exactly the same kind of problem a physicist faces when studying a system composed of a humongous number of particles making up a fluid. On the individual particle level, the complexity of the problem makes the prediction of its future motion absolutely impossible. Yet, by using statistical methods and averaging over all the particles, laws of fluid motion can be derived. In the same way, the neoclassical laws of economics are derived empirically by observing human economic behavior over entire populations. The one exception to this statement is Ricardo’s law of comparable advantage, which is the one neoclassical law that can be rigorously proved mathematically. All four of the neoclassical laws (the law of supply and demand, Ricardo’s law of comparable advantage, Say’s Law, and the law of marginal utility) are with the exception of Say’s Law almost universally accepted as generally applicable. They hold sway in socialist economies just as much as in capitalist economies. In capitalist economies, however, these laws are friends of the people, while in socialism they are made into the enemy.

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