Question

what would it take for aggregate output to always be absorbed by aggregate demand, so that overproduction will never be a problem? Does the "invisible hand" constitute reasonable metaphor for describing the behavior of economies?

Answer 1

The market mechanism is an automatic mechanism which is regulated by the invisible hands of demand and supply. The supply moves in the same direction of price and demand moves in opposite to price. This opposite movement of the supply and demand brings equilibrium in the market. The classical economist argue that the free play of demand and supply always bring full employment of resources through the equality of aggregate demand of output and aggregate supply of output. Their view is based on the assumption of Say’s Law of market which states ‘supply creates its own demand’. Every producer supplies his goods in the market in order to get other goods in exchange. When a producer produces goods he pays to the factors in the form of wages, interest, rent and profit. This income is used to demand the goods produced. Accordingly, demand is created simultaneously with the supply of goods. Thus there is no problem of overproduction or unemployment in the economy. In any case where the aggregate supply is greater than the aggregate demand the fall in price brings the equilibrium between the two.

But in real life, people do not spend all their money income on goods and services. They save a part of income. Therefore aggregate demand falls in the same proportion as the amount of saving. Thus it causes aggregate demand falling short of aggregate supply. However the classical economist asserted that Say’ Law would hold well in the situation of saving. This is because people convert their saving into investment. The equality between saving and investment is brought about through the fluctuation in the rate of interest. As a result, the aggregate of consumption and investment become equal to aggregate supply. Thus the classical economist held the view that in the event of equality between saving and investment, there will be equality of aggregate demand and aggregate supply. Thus there will be equality in the goods market and no chance of overproduction or glut in the market. The factor market is also get equilibrium with the working of invisible hand of demand and supply. In factor market those who wants to employment cannot be found remaining unemployed. This fullemployment is brought about by the movement of the invisible hands of demand and supply of factors. Thus in classical view the invisible hand has the reasonable metaphor of absorbing the aggregate output by the aggregate demand.

But according to the view of Keynes the invisible hand does not have the metaphor of equality between aggregate supply of output and aggregate demand. The reason is that as income increase the consumption decreases because the marginal propensity to consume decrease and saving increase since the marginal prophecy to save increase as income increase. This increased saving cannot automatically be fully channeled into investment. The saving and invest is done by the different categories of people. The investment decision is depends upon the expected profit (MEC) rather than the rate of interest. In a situation of profit less than the rate of interest investment will fall short of saving. In such a situation the invisible hand fails to bring equality between the aggregate supply and demand. Thus the product market suffers from disequilibrium due to lack of aggregate demand.

Again the factor market also cannot bring equality of supply and demand because of the existence of strong trade unions who oppose a reduction in wage. If the wage is rigid in downward direction the aggregate demand of factor cannot equate with aggregate supply. In short in Keynesian view, the invisible hand both in product market and factor market does not have the metaphor of absorbing aggregate supply by aggregate demand.