Saturday, October 24, 2015

Demand Creates its Own Supply

I have been teaching basic Keynesian economics this week to my undergraduate class and I have just completed a new book manuscript with the working title of Prosperity for All, that will be coming soon to a book
store near you. I am thus highly attuned to the debate over the connection between savings and investment. That debate resurfaced with a vengeance this morning on Twitter when Noah Smith and Jo Michell, among others, engaged in a sometimes testy exchange on the role of the State in promoting investment. Since that debate is at the core of Keynesian economics, and since my class is prepping for Monday’s midterm, this seems like a great opportunity to enlighten readers of all varieties on what Jo and Noah were on about.

Keynesian economics begins with a basic definition. To sharpen the discussion, I will abstract from the role of government and I will abstract from foreign trade. In an economy with no government, and no foreign trade, we may define all of the goods produced in the economy to be of two types; a consumption good or an investment good. Since all of the income earned by the factors of production is earned from producing either consumption goods or investment goods, it is IDENTICALLY TRUE that:

1) YN = CN + IN

Here, YN is the dollar value of all of the incomes earned by workers, capitalists and landowners in the process of producing consumption goods worth CN dollars and investment goods worth IN dollars. The letter N stands for “nominal”.

In recent discourse, economists have sometimes resorted to the fiction of the one good representative consumer model in which we assume that the economy produces a single good from capital and labor. That IS NOT what I am assuming here. YN IS NOT a single good. It is the dollar value of all final goods produced in a given year.

To move from nominal values, to real values, we need to deflate equation (1) by a nominal index. The Keynes of the General Theory made a very sensible suggestion that has been ignored for the past eighty years and that I resuscitated in my book, Expectations Employment and Prices. He suggested dividing both sides of identity (1) by a measure of the money wage. That is a great way to normalize measurements over time because the money wage grows for two reasons. It grows when there is inflation in the dollar. And it grows when there is real economic progress. Dividing equation (1) by the money wage leads to the following identity where Y, C and I represent GDP, consumption and investment measured in wage units.

2) Y = C + I

Equation (2) is, at this point, still an identity. Now comes the economics. Keynes introduced two simple pieces: A theory of aggregate supply. And a theory of aggregate demand.

The Keynesian theory of aggregate supply asserts that firms will increase or decrease the number of workers they employ in order to produce as many goods as are demanded. The French Economist John Baptiste Say, famously asserted that: Supply creates its own demand. Keynes turned this proposition on its head. In Keynesian economics: Demand creates its own supply.

Keynes argued that the economy is typically producing at less than full employment. And as long as there is any involuntary unemployment: everything that is demanded will be supplied. That central proposition can be represented by a graph in which expenditure appears on the vertical axis, and income appears on the horizontal axis. A line at 45 degrees to the origin, for which income equals expenditure, IS the Keynesian aggregate supply curve.

Keynes did not explain why firms would respond to deficient demand by reducing employment, as opposed to cutting wages. He thought that workers would resist reductions in their wages, but he did not believe that sticky wages were central to his argument. Although Keynes never provided a fully articulated theory that would reconcile his ideas with microeconomics: I have provided such a theory. In my published research, I explain why the forty five degree line is an aggregate supply curve. My work is grounded in the microeconomics theory of search. But I digress. More on aggregate supply in a future post.

Recall that my purpose here, is to explain the debate between Noah and Jo on the equality of savings and investment. In order to move forward with that purpose, let us accept, for now, the Keynesian theory of aggregate supply and move to the Keynesian theory of aggregate demand.

Keynes asked, what determines expenditure on consumption and investment goods? He claimed that aggregate expenditure on consumption goods, by a community of people, will increase when the income of the community increases. But it will increase less than proportionally. He called the constant of proportionality, the marginal propensity to consume. We may represent that idea by equation (3):

3) C = a + bY

Here, ‘a’ is a constant that I will call autonomous consumption expenditure and ‘b’ is the marginal propensity to consume.

Finally, we need a theory of investment. Investment, in the basic version of Keynesian theory, is a highly unstable variable that is driven by the animal spirits of investors. Each year, investors make plans and they enact those plans by placing orders for new machines and factories. I will represent the planned expenditures of investors with the symbol IP. Let me also use the symbol X to represent total expenditure and XP to represent planned expenditure. That leads to the following equations, 

4) X = C + I

5) XP = C + IP

and, using the theory of consumption from (3)

6) X = (a+I) + bY

7) XP = (a+IP) + bY

Equations (6) and (7) distinguish expenditure, X, from planned expenditure, XP. It is identically true that

8) X = Y

But it is only true, in equilibrium, that

9) XP = Y

The difference between I and IP is that goods that are produced, but not sold, are DEFINED to be investment goods. If Toyota builds 100,000 cars, but only 20,000 are sold, the 80,000 unsold cars are defined to be investment expenditure. But they are not defined to be part of planned investment expenditure. An economy in which unplanned inventories increase by the real value of 80,000 cars is not in equilibrium. To restore equilibrium, Keynes argued that Toyota will fire workers, those workers will spend less, and income will fall to the point where saving equals planned investment.

What about the equality of savings and investment? By definition, every dollar not spent, is saved.

10) S = Y – C

Here, S represents savings. A little further algebra establishes that, when Y = XP, it is simultaneously true that

11) S = IP

Here, finally, is the answer to the exchange between Jo and Noah. It is always true, in equilibrium, that savings is equal to investment. In Keynesian theory, it is income and employment that adjust to make this so. In Keynesian economics: Demand creates its own supply.


  1. I think you mean, income falls to the point where SAVINGS equals planned investment (above 10).

  2. Roger: "The difference between I and IP is that goods that are produced, but not sold, are DEFINED to be investment goods."

    Yes. But let's imagine a world where all goods are services, like haircuts, that are produced only when the buyer walks in the door and gives the seller a $20 note. There cannot be an unsold haircut produced.

    I think we need to distinguish 4 quantities:

    1, Q = actual number of haircuts produced bought and sold

    2. Qd = number of haircuts people want to buy

    3 Qs = number of haircuts people want to sell

    4. Qe = people's expectation of Q

    The behavioural equations of the Keynesian Cross are:

    Q = min{Qd,Qs} Short-side rule

    Qd = F(Qe) Consumption function

    Qe = Q equilibrium condition

    Then we have a simultaneous moves Nash Game.

    (I have ignored investment to keep it simple, but investment could be services too (training hairdressers).

    1. Nick
      If all goods were consumption goods and services, there would be no investment and no saving. If hairdressers need to be trained, the accumulation of inventories would be reflected in unemployed hairdressers.

    2. Or in fewer people wanting to be hairdressers. Thus, the disinvestment would appear in lower hair school enrollment and decreased popularity of the career. We're seeing this with lawyers even now.

  3. Crystal clear on accounting identities, which I find even among graduate business students who took undergraduate basic economics were either not taught or were so lightly covered they are soon forgotten.

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  5. Thanks David
    I learned intermediate macro from Dornbusch and Fischer's text at a time when we still taught Keynesian economics to our students. We have lost a lot in the rush for microfoundations. As my good friend Axel Leijonhufvud once remarked: from the perspective of Los Angeles, entertainment capital of the world, modern macroeconomics is much like modern Hollywood movies. The pyrotechnics are spectacular. But the plots are sadly lacking.

  6. I never understood the sticky wage problem. The reasoning for layoffs as opposed to wage cuts seems rather obvious to just about everyone except economists.

    Yes, you could cut pay, but then people would show up at the factory and do what? You could continue production, but then you'd be buying raw materials, paying for power and all that other stuff to produce things that you can't sell. You'd even have to pay for some place to store all the stuff.

    Alternatively, you could pay less and tell people to do less or take longer coffee breaks, but why? You are running a factory, not a social club.

    (I've had a similar problem understanding the problem with demand creating supply. Now and then supply creates demand, but this usually involves some technological innovation or new product category. For existing categories of goods and services it is usually demand that creates supply. Maybe this is because I hang around with small business owners and not titans of capitalism.)

    1. A lot of economists are, whether they know it or not, still in thrall to Say's Law, in which there is no mass unemployment because firms and workers have no market power and must instantaneously or near-instantaneously adjust their prices and wages. They aren't willing to abandon the notion of flexprice markets.

  7. Fundamentally flawed
    Comment on Roger Farmer on ‘Demand Creates its Own Supply’

    You say “Keynesian economics begins with a basic definition.” This is true. The fact of the matter is, though, that this basic definition is provably false and, worse, that Keynesians have not got the point until this very day (2011b).

    The final proof of widespread logical incapacity is that the most elementary accounting identities have been messed up. As a centerpiece of the General Theory Keynes formulated the foundational syllogism of macroeconomics. “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

    This elementary two-liner is conceptually and logically defective because Keynes did not come to grips with profit (Tómasson and Bezemer, 2010, pp. 12-13, 16). The fault is in the premise ‘income = value of output’. This equality holds initially only in the limiting case of zero profit in both the consumption and investment good industry. Hence, Keynes formally dealt with a zero profit economy without being aware of it (2011a). This means in concrete terms that the multiplier formula is provably false.

    The first logical blunder kicked off a chain reaction of mistakes, because when profit is not correctly defined, income is not correctly defined, and then saving is not correctly defined. By consequence, all I=S models are logically defective.

    The root cause of all accounting errors/mistakes is a complete lack of understanding of what profit is. The conceptual error carries over to national accounting (2012).

    You conclude “Here, finally, is the answer to the exchange between Jo and Noah. It is always true, in equilibrium, that savings is equal to investment.”

    Definitively not! It is always true that Qm=Yd+I-Sm, that is, monetary profit is equal to distributed profit plus investment expenditure minus household sector's monetary saving. Saving and investment are NEVER equal. This is a testable proposition.

    To repeat: ALL I=S models are logically defective because they fail to consistently integrate profit. A short formal proof has been given on a parallel thread.*

    Not only Jo and Noah got it wrong, but Roger, too. Not to forget, of course, Keynes and Hicks and Krugman (2014) and the rest of the logically feeble profession.

    Egmont Kakarot-Handtke

    Kakarot-Handtke, E. (2011a). Keynes’s Missing Axioms. SSRN Working Paper
    Series, 1841408: 1–33. URL
    Kakarot-Handtke, E. (2011b). Why Post Keynesianism is Not Yet a Science. SSRN
    Working Paper Series, 1966438: 1–20. URL
    Kakarot-Handtke, E. (2012). The Common Error of Common Sense: An Essential
    Rectification of the Accounting Approach. SSRN Working Paper Series, 2124415:
    1–23. URL
    Kakarot-Handtke, E. (2014). Mr. Keynes, Prof. Krugman, IS-LM, and the End of
    Economics as We Know It. SSRN Working Paper Series, 2392856: 1–19. URL
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money.
    The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke:
    Macmillan. (1936).
    Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and
    Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34.
    * See the Uneasy Money blog
    or the summary ‘End of confusion’ on the AXEC blog

  8. Very nice post.

    That’s roughly the way I remember it being taught decades ago.

    I’ve had a long running exchange with David Glasner concerning this subject. My view on it is that investment and saving are always equivalent in quantity – throughout the process of the Keynesian multiplier – and not just in equilibrium. I don’t believe this is inconsistent with any sound explanation of the multiplier otherwise – such as your own description here. It’s just a refinement that maps the algebra of the multiplier to the corresponding financial accounting at each step, with a slight twist on the interpretation of how and when saving occurs in the process. After multiple posts that have touched on this at Uneasy Money, my latest comment is here:

    1. The idea of saving and investment being equal, is exclusively implied by income-expense conservation in NIPA/FOFA (see my detailed comment below to you and Roger). Accounting identities are behavior-neutral, and S-I equilibrium is a specific behavioral assumption. Also, total S and I cannot be in disequilibrium at any time interval.

  9. Thanks JKH
    Here Is a clickable link to your comment over at David Glasner's blog

  10. I=S: Mark of the incompetent
    Comment on JKH and Roger Farmer on ‘Demand Creates its Own Supply’

    I=S is provably false but the representative economist never got the point. To some degree this is understandable because the deeper conceptual problem is that the representative economist does not even know what profit is because, as the Palgrave summarizes “A satisfactory theory of profits is still elusive.” (Desai, 2008, p. 10)

    In simple words this means that all economic models are defective — except those that come explicitly to grips with the pivotal economic concept profit. None are known from Orthodoxy and Heterodoxy. And this in turn means that all economic advice lacks a sound scientific foundation.

    The I=S blunder is not a single or isolated event but a rather typical outcome of proto-scientific thinking and widespread misapprehension of scientific methodology.*

    The following economists are representatives of the general intellectual malaise which manifests itself in the longstanding I=S debate. The list could be easily prolonged.**

    — Keynes, see Keynes’s Missing Axioms, working paper

    — Hicks/Krugman, see Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It, working paper

    — Farmer, see Fundamentally flawed, post

    — Syll, see Is Keynes acceptable?, post

    — Glasner, see End of confusion, post
    and see Quod erat demonstrandum, post

    — JKH, see Tricky business, post

    — Radford, see No culpa, only stultitia, post

    — DeLong, see Sales talk vs. Science, post

    — Douglas, see Unaccountable, post

    — Mitchell, see Modern moronomic theory, post

    — Keen, see Mental messies and loose losers, post

    — Wren-Lewis, see The subtle distinction between storytelling and science, post

    For a crash course in profit theory see The Profit Law, post

    Egmont Kakarot-Handtke

    Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume
    (Eds.), The New Palgrave Dictionary of Economics Online, pages 1–11. Palgrave
    Macmillan, 2nd edition. URL

    * The correct relationship between monetary profit Qm, distributed profit Yd, investment expenditures I and monetary saving Sm is given here:

    ** For more details of the big picture see cross-references I=S

  11. Roger and JKH,

    The accounting identities are behavior-neutral and independent of schools of economic thought. In fact, NIPA/FOFA identities can be described declaratively instead of behavioral procedures as follows.

    (Economy Axiom): my expense is your income
    (E1 –Y1) + (E2-Y2)+ (E3-Y3)+ … = 0 for all involved sectors 1, 2, 3….

    (Finance Axiom): my financial liability is your financial asset
    (A1-L1) + (A2-L2) + (A3-L3) + … = 0 for all involved sectors 1, 2, 3….
    (Flow Axiom) Economic production-income flows are based on exchanging either goods, services, or labors with financial assets.
    Ex-Yx = Ax-Lx for each sector x =1,2,3, …

    (Saving Definition) Sector investment (non-financial assets) + (income – expense) (net financial assets). People have missed this definition and meaning in discussions. NIPA/FOFA considers sector investment (Ix) as “non-consumed spending” and thus it is a part of sector saving (Sx) for non-financial assets in addition to financial assets saving (Ex-Yx).

    Sx= Ix + (Ex - Yx) , for sector x = 1,2,3,…

    Thus we can derive this sector S-I balance from saving definition and axioms.
    (S1-I1)+(S2-I2)+(S3-I3)+ …. =0

    In summary,
    (1) Some economic conservation laws for saving and investment are:
    For each sector x, Sx-Ix = Ex –Yx = Ax- Lx
    For all sectors in total: S – I = 0, E – Y = 0, A- L = 0

    These balances are just three views (distribution, production and finance) of the same economy

    (2) Economic microfoundation is based on expansion/contraction (or JKH’s multiplier) of conservation laws. During expansion/contraction, we can monitor the stability and sustainability from examining the quantity and quality of components inside S, I, E, Y, A, and L for each sector and overall.

    (3) I believe that we need to add business net operating surplus(NOS) to total worker wages (YN) in the equation as follows

    NOS + YN = CN + IN

    NIPA production and income balance is:

    GDP = I+C+G+X-M
    GDI = NetOperatingSurplus + Wages + CFC + Tariffs - Subsides
    GDP= GDI

    Thus, we always have production-income conservation between labor market (wages) and goods market (GDI – wages). The multi equilibria appear in both labor market and goods market with opposite direction(i.e. conservation).

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  13. Professor Farmer, did Keynes discuss the bootstrapping problem affecting the economy? Incomes have to be anticipated ex-ante in order to be generated ex-post. In other words, assuming endogenous process toward full employment is equivalent to assuming that income expectations by the unemployed generate the aggregate demand necessary to get them employed.

    Historically, the economy has bootstrapped by relying on excess borrowings by those with positive income expectations. Such borrowings in excess of desired savings generate the excess demand necessary for the economy to move a step closer to full employment. The problem is that borrowing is predicated on expectations of the Future, which is inherently uncertain. If such expectations are not realized, excess borrowings can quickly turn to a shortage depressing aggregate demand and giving rise to the business cycle. I develop these ideas in more details here

    On a side note, the bootstrapping problem provides a theoretical framework in support of the notion that the economy is not self-correcting and recessions have permanent effects along the lines of your unit-root arguments...


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