Say’s Law Today

August 5, 2009

by Jerry O’Driscoll  



In the General Theory, J. M. Keynes recast Say’s Law as the proposition that “the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output.” That formulation would be foreign, if not incomprehensible, to any economist who had ever subscribed to Say’s Law.  That law negates the concept of “output as a whole”    

The classical economists typically articulated propositions in terms of long-run comparative statics (Ricardo being the prime example). But all (even Ricardo) also analyzed short-run dynamic processes.  In modern parlance, excess demand in some markets and excess supply in other markets were entirely consistent with Say’s Law. And that included inter-temporal demand and supply.  

Even in situations of disequilibrium (to use modern phraseology), long-run propositions are a discipline on analysis.  They point in the direction toward which markets are moving.  By contrast, propositions about transitional effects, like the Paradox of Thrift, cannot be generalized. They are not true in the long run.  When some economists enunciate them as permanent truths, they become dangerous nonsense that misleads policy makers and confuses the public.  

Consider the current economic situation.  A financial crisis has been brought on by, first positive, and then negative monetary shocks.  In the short run, individuals are increasing their demand for money (velocity is declining), and are simultaneously increasing their long-run, desired savings to a more normal rate.  These effects combine to place downward pressure on nominal demand in many markets.  

But the decline in nominal demand is not evenly spread across all markets.  If demand is to be stimulated consistent with the new consumption/savings equilibrium, it would need to be supplied in the precise proportions that correspond to the new pattern of demand across markets (including inter-temporal markets).  The information requirements to accomplish that task are nothing short of what would be required for comprehensive economic planning of the economy.  Moreover, Public Choice tells us that stimulus will always be applied according to political, not economic, criteria.  

If nominal demand is falling at uneven rates, then relative prices are changing.  The same self-regulating forces are at work as described in microeconomics. Resources are being re-allocated across markets even as this is being written.  A macroeconomic model with one good (output), one price, one interest rate, one wage rate, etc. is incapable of capturing those forces. The rationale for stimulus makes sense only in terms of such models and not in terms of how market economies actually work.

15 Responses to “Say’s Law Today”

  1. […] and debate.  Time for some remedial summer school education courtesy of Hayekian macroeconomist Gerald O’Driscoll: Say’s Law of Markets answered the fears of under-consumption as the spreading industrial […]

  2. This is great stuff Jerry. Interested readers might wish to see two pieces of mine on Say’s Law from an Austrian perspective:



  3. Mario Rizzo Says:

    When does the Keynesian short run end and the classical long run begin? Did Keynes think the Paradox of Thrift always held? He couldn’t have, could he? How can we draw the line?

  4. There are opposing forces at work. The so-called short-run forces slow the long-run adjustment. The classical long-run adjustment begins immediately. Monetary factors mask it. The Paradox of Thrift derives from liquidity preference operating to prevent the needed drop in interest rates. Did Keynes believe liquidity preference always held?

  5. jakemccloskey Says:

    I’m confused. I always thought the Paradox of Thrift was simply an application of the concept of sticky wages and prices. As long as prices are fixed, the stock of bank credit is also fixed because increases in consumer savings will be offset by decreases in the savings of firms. But this phenomenon is entirely independent of relative price changes. Even if prices are changing relative to each other, the paradox holds as long as they are not also moving downward fast enough (and I realize that what constitutes “fast enough” depends on the particular market). I don’t see how this addresses that point, unless I’ve completely misunderstood something here.

  6. Zombiehero Says:

    Great stuff.
    I have the same question as you Prof Rizzo, when does Short Run end, and when does short run stimulus start to negatively effect Long Run production?

  7. Bill Woolsey Says:

    There is little reason for a reallocation of resources reflecting some new saving/consumption balance to be associated with lower aggregate nominal expenditure. Less nominal expenditure on homes (and perhaps less consumer goods fiananced by home equity loans) and more nominal expenditure on other capital goods. A change in composition rather than total amount.

    A tempoary increase in money demand/decrease in velocity due to uncertainty and fear associated with the long run adjustment, given the nominal quantity of money, requires an increase in the purchasing power of money/reduction in the price level. Because prices and nominal incomes (like wages) are sticky, real expedniture falls as does aggregate output. This process almost certainly involves changes in relative prices as well. Most obviously because some prices are stickier than others, but the processes by which real expenditure recovers might have nothing to do with the underlying long run pattern of demand.

    For example, the pigou effect works through higher real balances, higher real wealth, and increased consumption. This appears inconsistent with the long run pattern of demand–assumed to be less consumption. Will those spending because of the temporary increase in real balances be the same ones who have reduced consumption below long term levels (which are by assumption reduced as well) because of uncertainty?

    Because the increase in money demand is termporary, any decrease in the price level is termporary. This will result in lower, perhaps negative real interest rates, which are not consistent with long run equilibrium. That is, extra low real interest rates (perhaps negative) convince firms to invest despite the uncertainty. Will those motivated to invest in that way be the same ones who would invest more in the contest of a smooth adjustment of the composition of demand way from housing and other consumption and towards investment? It seems unlikely.

    My point is that the pattern of demand and relative prices associated with the market process that corrects a temporary increase in the demand for money is unlikely to be less distortionary than a termporary increase in the nominal quantity of money.

    To the degree anyone takes the particular patterns of demand and relative prices that exist during a period of high money demand due to uncertainty (and that includes interest rates) as being at their new long run levels, then they are being myopic. Avoiding malinvestment created by myopic entrepreneurial error is not a reason (in my view) for the nominal quantity of money to fail to rise to meet this temporary demand, and maintain nominal expenditures.

    I am sensitive to public choice concerns, and a rule regarding the growth rate of base money (say, zero) is easy to enforce, I think rules regarding the growth path of aggregate nominal expenditures are worth a try.

  8. Does anyone see sticky wages and prices out there? In the private sector? In any case, the Paradox of Thrift has nothing to do with sticky wages and prices. It is about sticky interest rates brought on by liquidity preference. If it were true generally, then we would be in a Malthusian dead end with no prospect of capital accumulation, productivity increases and economic growth. The existence of all of these refutes the Paradox of Thrift. On the long-run, again, the long-run adjustment process can begin immediately. Short-run monetary dynamics, like falling velocity, can mask or impede the long-run adjustment. The long-run and short-run are properties of models and don’t necessarily correspond to clock time.

  9. Bill Woolsey Says:

    I see evidence of sticky wages and prices.

    Nominal expenditures have fallen, pretty much across the board.

    Real output has dropped in just just every sector of the economy.

    The notion that there has been massive structural unemployment with total output falling because of bottnecks in high demand sectors seems disconnected from reality.

    Sticky wages and prices isn’t the same thing as effective price and wage floors across the board. Evidently, prices and wages are not dropping enough to maintain the real volume of sales. Where are the industries that have rising relative prices, real profits, and are expanding production and employment as fast as they can? What are the bottlenecks in these industries?

  10. Jake McCloskey Says:

    I have to respectfully disagree on the Paradox of Thrift. I think it has everything to do with sticky prices, at least in the modern New Keynesian version that I’ve heard. Take the extreme case where prices are fixed. Using a loanable funds model, there could be no increase in the supply of loanable funds as increases in savings by households would automatically lead to decreases in saving by firms. What might happen, however, would be a leftward shift in the demand for loanable funds, leading to a lower interest rate and lower investment.

    Obviously prices aren’t fixed in the real world, but as long as they are at least sticky the Paradox will hold to a certain degree. Of course, this is only applicable to periods of collapse in nominal spending, such as during a recession. I don’t think anyone today views it as a general phenomenon.

  11. In either version, the Paradox of Thrift would imply frustration of attempts to increase savings and lack of capital formation. Has that characterized either Western economies over time, or the recent housing boom? We are dealing with the after- effects of excess- or mal-investment and record low personal savings. “Sticky” prices are a complete canard. The issue was discussed at great length in Axel Leijonhufvud’s book on Keynes.

  12. Jake McCloskey Says:


    Ok, I misunderstood.

    “Has that characterized either Western economies over time, or the recent housing boom?”

    Again, I don’t think many view it as something that holds at all times, even if Keynes did.

    I’m not defending Keynes or fiscal stimulus but are you saying that short run processes like the Paradox can’t have real effects?
    Relative prices need to adjust and fiscal stimulus is likely to impede that adjustment process, but I see short-run frictions as being potentially distortionary as well.

  13. It is important to distinguish between an increase in the demand for money, and increase in desired savings (which Keynes did not). Almost all monetary theorists before and after Keynes acknowledged the potential disruption of an increase in money demand. Since money has no market of its own, the increase in demand is potentially disruptive across all markets. (Our free banking colleagues would remind us even that is questionable.) An increase in desired savings is an increase in demand for goods and services (Smith’s point). It is not disruptive in and of itself. It is folly for economists to disparage savings. Thanks heavens policymakers in China and India missed that lesson. A billion people moved out of poverty because thrift was practiced, not disparaged.

  14. Drewfuss Says:

    Could someone comment on the status/validity of the liquidity preference interest rate theory for a metallic money economy vis-à-vis a fiat money/credit economy?

    Does not the liquidity preference theory depend implicitly on money being physical (or backed by a physical equivalent), and therefore potentially scarce relative to the demand for money?

    In comparison, in a fiat money economy, is not the supply of money only constrained by its demand, therefore the supply being essentially infinite? (I believe this was the position taken by N. Kaldor.) Consequently, how would an increase in money demand result in higher interest rates if there are no constraints on the short run supply of money, as potentially there would/could be with metallic money?

    In general, with the demise of the gold standard during the depression, was not the liquidity preference theory obsolete before it was published?

  15. Atiqullah Says:

    is the Say’s law is Applicable in Credit Market or not and Explain it briefly.

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