AGGREGATE DEMAND AND SUPPLY Also by B. Bhaskara Rao COINTEGRATION FOR THE APPLIED ECONOMIST (editor) THE ECONOMETRICS OF DISEQUILIBRIUM MODELS (co-author) Aggregate Demand and Supply A Critique of Orthodox Macroeconomic Modelling Edited by B. Bhaskara Rao Associate Professor and Director of Postgraduate Studies School ofEconomics University ofNew South Wales First published in Oreat Britain 1998 by MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire R021 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 978-1-349-26295-3 ISBN 978-1-349-26293-9 (eBook) DOI 10.1007/978-1-349-26293-9 First published in the Uni ted States of America 1998 by ST. MARTIN'S PRESS, INC .. Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 978-1-349-26295-3 Library of Congress Cataloging-in-Publication Data Aggregate demand and supply : a critique of orthodox macroeconomic modelling I edited by B. Bhaskara Rao. p. cm. Includes bibliographical references and index. ISBN 978-1-349-26295-3 1. Demand (Economic theory) 2. Supply and demand. I. Bhaskara Rao, B., 1939- . HB842.E85 1998 338.5'21-DC21 97-18334 CIP Selection, editorial matter and Chapters I and 4 © B. Bhaskara Rao 1998 Chapters 2, 3, 5-11 inclusive © Macmillan Press Ltd 1998 Softcover reprintofthe hardcover Ist edition 1998 978-0-333-69147-2 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W I P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10987654 3 2 I 07 06 05 04 03 02 01 00 99 98 Contents Preface xi Notes on the Contributors xiii 1. Introduction 1 B. Bhaskara Rao 2. Aggregate Demand in Principles Textbooks Ken McCormick and Janet M. Rives 2.1 Introduction 11 2.2 Current Textbook Presentations 11 2.3 Other Effects of Price Changes 17 2.4 Additional Considerations 19 2.5 The Need for Alternatives 21 3. Aggregate Demand Curves: A Guide to Use and Abuse Revisited Peter H. Hall and Malcolm L. Treadgold 3.1 Introduction 25 3.2 The Conventional Curve 26 3.3 Problems with the Conventional Approach 28 3.3.1 The Volume of Real Aggregate Demand 28 3.3.2 The Measurement of Excess Demand/Supply 30 3.3.3 Interdependence of Aggregate Demand and Supply 31 vi Contents 3.4 Two Alternatives 33 3.4.1 Rowan's Curve 33 3.4.2 Corden's Constant-MV Curve 39 3.5 Conclusion 42 4. What is the Matter with Aggregate Demand and Supply? B. Bhaskara Rao 4.1 Introduction 45 4.2 Aggregate Demand, Supply and the ISLM Model 46 4.3 The Neo Classical Version 56 4.4 The Keynesian Approach 60 4.5 Conclusions 65 5. Walrasian, Non-Walrasian and Post-Walrasian Perspectives on the ADAS Model: Theoretical and Pedagogical Implications Ralph C. Allen and Jack H. Stone 5.1 Introduction 67 5.2 Institutional Environment 68 5.3 Institutional Environment Behind ISLM 70 5.4 Inconsistencies in ADAS and Proposed Alternatives 72 5.5 Post-Walrasian Coordination in ADAS 76 5.6 Conclusion 80 Contents vii 6. The ADAS Model: Two into One Won't Go Roy H. Grieve 6.1 Introduction 83 6.2 The Textbook Model 84 6.3 Two Theories, One Model: No Go 88 6.4 The Root of the Problem 90 6.5 Conclusion 93 6.6 Postscript 94 7. Defending ADAS: A Perspective on the ADAS Controversy Peter Kennedy 7.1 Introduction 95 7.2 The Rise of ADAS 95 7.3 No Internal Inconsistency 97 7.4 ADAS Can be Confusing 99 7.5 Dynamics 102 7.6 Conclusion 104 Appendix to Chapter 7: Survey Instrument 105 8. Theoretical Inconsistencies in the ADAS Model: Can the Model be Rehabilitated? T. Windsor Fields and William R. Hart 8.1 Introduction 107 8.2 The Textbook ADAS Model 110 8.3 The Aggregate Demand Curve 112 8.4 A Theoretically Consistent ADAS Model 116 8.5 Short Run Aggregate Demand 126 viii Contents 8.6 Price Level and Interest Rate Determination in ADAS Model 128 8.7 Conclusion 135 9. Acceptable and Unacceptable Dirty Pedagogy: The Case of ADAS David Colander and Peter Sephton 9.1 Introduction 137 9.2 What the ADAS Model is Supposed to Accomplish 138 9.3 Problems with ADAS Analysis 138 9.4 Macro Policy Model 142 9.4.1 The Renaming of the AED Curve 143 9.4.2 Using an Aggregate Supply Path Rather than a Supply Curve 144 9.5 The Aggregate Supply Path Alternative 151 9.6 The More Limited Applicability of the Macro Policy Model 152 9.7 Summary 153 10 Aggregate Demand and Supply Analysis: A Story in the Wrong Language John W. Nevile 10.1 Introduction 155 10.2 Language of General Equilibrium Comparative Statics 157 10.3 Marshallian Analysis versus General Equilibrium 162 10.4 Not only the Wrong Language but an Unfamiliar Dialect 166 10.5 A Possible Alternative 168 10.6 Conclusion 174 Contents ix 11 A Simple Analysis of Price and Output Determination: A Model with Imperfect Competition Corrado Benassi, Alessandra Chirco and Caterina Colombo 11.1 Introduction 177 11.2 Aggregate Demand and Supply Under Imperfect Competition 180 11.3 The Role of Wage Rigidities 182 11.4 A Macromodel of Imperfect Competition 185 11.4.1 Firm's Behaviour 185 11.4.2 Union's Behaviour 187 11.5 Aggregate Behaviour of Firms and Unions 189 11.6 Equilibrium Under Full Nominal Flexibility 191 11.6.1 Determination and Properties of Equilibrium 191 11.6.2 Aggregate Demand and Aggregate Supply Under Full Flexibility 195 11.7 Equilibrium Under Nominal Rigidities 195 11.7.1 Equilibrium Under Nominal Wage Rigidity 297 11.7.2 Aggregate Demand and Supply Under Nominal Wage Rigidity 198 11.7.3 Equilibrium Under Nominal Price Rigidity 200 11.8 Concluding Remarks 202 Appendix to Chapter 11 205 Bibliography 209 Index 223 Preface The aggregate demand and supply model is extensively used in the current macroeconomics textbooks to explain the working of the economy, to evaluate rival macroeconomic paradigms and to illustrate the effects and policy implica­ tions of changes in the exogenous variables. However, many teachers are becoming uncomfortable with its logical foun­ dations and the claim that it is general and encompasses al­ ternative macroeconomic paradigms. Although there have been severe criticisms of this model, textbook writers were reluctant to develop more convincing alternative expository models. That the textbook aggregate demand and supply model has logical pitfalls was pointed out by Rowan (1975), Hall and Treadgold (1982), Hansen, McCormick and Rives (1985) and Rao (1991). Subsequently several important papers have been published in various issues of the A us­ tralian Economic Papers and the Southern Economic Jour­ nal. None of this had any significant effect on the textbook model and the way we teach macroeconomics. However, more recently three important papers by Colander (1995), Nevile and Rao (1996) and Grieve (1996) have once again raised doubts about the logical soundness of the derivation of the aggregate demand and supply model. These recent publications have encouraged me to bring out this collec­ tion of essays by requesting others, with similar concerns about the logical foundations of the basic macro model, to explore for some logically consistent alternative models for Xli Preface use in the textbooks and classrooms. It is hoped that this collection of essays will encourage many other teachers to extend our efforts. I am grateful to all the contributors to this volume for readily accepting my request to elaborate their earlier criticisms and suggest alternative models that may even­ tually replace the current unsatisfactory textbook macro model. I thank Tim Farmiloe, Publishing Director of the Macmillan Press, for his appreciation and timely approval of this project; Sunder Katwala, Commissioning Editor, and Karen Brazier, Editorial Services Controller of the Macmil­ lan Press for their help in preparing the final version of this book and Laser Campus, Madras, and Teresa Attfield, Au­ dio Visual Unit, University of New South Wales, for help with the diagrams and my son, Pankaj, for proof reading parts of the book. My final thanks go to John Nevile and John Lodewijks for helpful discussions on some method­ ological issues; to Roy Grieve and Malcolm Treadgold for valuable suggestions and corrections; to Kevin Fox for his timely help at a crucial stage in the production of this book; to my graduate students, Debarshi Nandy and Tania Dutta, for help with the preparation of the final version of this book and the index, and to the editors and publishers of the A us­ tralian Economic Papers for permission to use previously published material in Chapters 3 and 4. B.B.Rao Sydney Notes on the Contributors Ralph C. Allen is Professor of Economics and currently Head of the Department of Economics and Marketing at Valdosta State University, Valdosta, Georgia, USA.