10. Aggregate demand reworked

Classical theory is saying that aggregate demand is rising with falling prices of production that is more cheaply we produce, the more are the consumers willing to buy. Then, in connection with aggregate supply, which is rising with prices (the higher the prices, the more are producers willing to produce) it is possible to simulate that by lowering the price level (wage level as substantial part of production costs) there will be both an increase of demand and production and economy will get into new equilibrium where the production, employment will be higher and wages and prices lower.

This is the model upon which the theory of austerity is based on and which is asking for internal devaluation in countries hit by recession as a means to restore economic growth and competitiveness. Through forced fall in wages it is trying to achieve growth in production as well as demand (move from X to Y)

Even it may look logical at the first glance, there is one important wrong assumption which is making this model invalid and highly dangerous and harmful tool of macro economical policy which is driving whole nations to the dead end and misery of ever increasing unemployment and fall in GDP. This wrong assumption is modelling the AD without its dependency of AS. Economists who designed these charts were not analyzing dependency of these aggregate values based on each other, they just used them as if they were completely independent. The lower the price, the higher AD – isn´t it simple enough and correct as well? The cheaper the goods, the more will the consumers buy. This logic seems to be unbreakable. The problem is that it is not quite so.

If the buying power (wages, pensions) was not coming from production but would be totally independent from it and generated to say from Mars, this model could be valid. But as the wages are not paid by Martians but companies we have to take into account also how much are consumers ABLE to buy (not just WANT) at different levels of prices and so wages. To want to buy is really nice but in real world of money is simply not enough to simply state that in theory lower prices will lead to more purchases. What matters at the end is its dependence from level of wages.

Price = Profitperunit + Aggregate Wagesper unit (costs)

AS = Q x (Profitperunit + Aggregate Wagesper unit)      >      AD = Q x Aggregate Wagesper unit

Therefore:      AS = Profit + AD

The outcome is striking:  AS is always higher then AD, and there is no equilibrium.

The real curves of AS and AD are kind of parallel and they do not cross.

This chart is coming from simple model, where company is making 10 products at different level of wages and 2 variants of profitability.


From the calculation and chart is obvious that AS – planned sales is rising based on wages( which represent all costs of company recalculated to wage equivalent of production) but is always higher then AD, and by exactly of amount of category of profit.

The higher the profit margin, the more is AS shifted upwards, which corresponds with classical theory of AS rising with price (the price is understood here as profit margin) and so the AS is in aggregate monetary volume higher.  With increasing profit margin the distance between AS and AD is getting bigger, which is signaling lower real level of realization than planned. If the selling price is growing as a result of profit margin, buying power distributed through wages is lower and the percentage of planned sales fulfillment is declining. Category of profit is lowering the available buying power, which represents AD.

This is quite clearly depicted in the next chart, which is based on similar principle, but here the wages (production prices) are stable, only profit is rising. So AD remains the same, given by level of wages and AS (planned level of sales) is rising based on level of profit margin. As buying power is not managing to even copy growth in AS, the distance between AS and AD is progressively growing.

This is happening in the economy where productivity of work is growing faster than wages.

The scissors between AS and AD are opening more and more.



So the real position of AS and AD is more like this:

This is a game changer. From this chart it is clearly visible that lowering of wages (AD moves from P0 to P1) leads to lower prices (we move to the left on AS as well) but also to lower potential output (Q1as) and lower aggregate demand (Q1AD). So theory of Austerity based on move from X to Y is not increasing the production and employment as expected but doing exactly the opposite: lowering the output and wages and prices. It is basically a deflation receipt.

No wonder that countries in Europe following this disastrous concept are only falling further and further into recession and there is no end to their misery.GDP is just falling and unemployment is rising. The difference between classical model and this is proper understanding of aggregate demand, which is fuelled by wages.