A Comment on “Does the Aggregate Demand Curve Suffer from the Fallacy of Composition”

Abstract

A recent article in this journal by Professors Saltz, Cantrell, and Horton questioned validity and existence of aggregate demand curve in macroeconomics.1 More specifically, authors contend that the aggregate demand problem ... is a classic example of fallacy of composition and proceed to investigate this contention within each of four theoretical arguments that have typi cally been used to support negative slope of aggregate demand curve. The purpose and assertion of this comment is that Saltz, et. al., have commit ted several methodological errors in attempting to establish potential ambiguities contained within traditional conceptualization and derivation of aggregate demand curve. When these errors are cor rected and ambiguities cleared, it seems quite logical that an aggregate demand curve should exist and that there should be an inverse relationship between general price level and aggregate quan tity of goods demanded. Perhaps most fundamental and obvious error occurs in analysis of international price level effect. The authors begin by noting that validity of this effect is tenuous because of a number of questionable assumptions that underlie it. They write, First this argument assumes a constant for eign price This assumption is not a weakness but rather a methodological inevitability stemming from ceteris paribus assumption that anchors all formal models in economic theory, both microeco nomic and macroeconomic. Indeed, authors rec ognize this critical assumption explicitly in their definition of aggregate demand. The implication of this assumption, of course, is that a change in any non-price level determinant of aggregate demand, such as foreign price level, only shifts a given aggregate demand curve. Changes of variables other than price level are irrelevant to fun damental issue of existence and logical consis tency implicit within aggregate demand curve derivation. With respect to Pigou effect, Saltz et. al. con tends unexpected changes in price level cause a redistribution of wealth or income, but not a loss of net income. Absent from analysis however, is acknowledgment that a price-level induced change in distribution of income per se can affect aggregate demand. Therefore, if distribu tion of aggregate income were endogenized, higher price level would redistribute income from lowerto higher-income individuals in authors' scenario, leading to a decrease in consumption spending and aggregate demand. This conclusion is supported by income studies, which have consis tently shown that families with lower incomes have higher average propensities to consume and likely have higher marginal propensities to consume than families with higher incomes. At least two problems are present with authors' analysis of Keynes effect. First, they appear to confuse a movement of money demand curve with movements along it when they write . .we can also expect a fall in real money demand as people reduce their holdings of mone tary assets in response to an increase in oppor tunity cost of holding money. As interest rate or opportunity cost of money increases from a high er price level reducing real money supply, resulting adjustment in money market is not a movement of money demand curve but rather a movement northwest along a given money demand curve, such that interest rate rises unambiguous ly with a corresponding reduction in investment spending and aggregate demand. Second, authors again violate ceteris paribus assumption in their analysis of Keynes effect when they permit inflationary expectations to change endogenously and simultaneously with respect to a change in price level. The end result is then blurred since it doesn't allow a clear delin eation of how an increase in price level alone leads to a decrease in real money balances and an