Aggregating Markets and Sectors
Aggregating, that is, adding together items to make a whole, is commonplace in economics. The notions of supply and demand, for example, depend on the aggregation or adding together of the demands of many individual buyers and the supplies of many individual sellers. Although all of economics uses aggregation, the amount of aggregation is much greater in macroeconomics than in microeconomics.
The whole process of aggregation involves conceptual problems and ambiguities, but the simplification that aggregation can introduce can more than pay for the problems involved. To illustrate the problems involved in aggregation, consider a discussion of the supply and demand for apples. In such a discussion, one has made a decision that certain items should be considered together--yellow and red apples, winter and fall apples, eating apples and cooking apples. When one discusses the "apple market," one implicitly assumes that the differences among the various varieties of apples are small enough to ignore for the purposes at hand, but the differences between apples and pears, very similar fruit, are too large.
For some purposes one might want to aggregate more and speak of the "fruit market" rather than the "apple market." Further aggregation would lead to the food market. At this level of aggregation, one is not only adding apples and oranges together, but also apples and beefsteak. Although this may seem like aggregation gone wild, macroeconomists customarily aggregate a great deal more. They discuss the market of goods and services, the labor market, and the financial market. The advantage of this drastic aggregation is that it simplifies the workings of the system to the point at which the human mind can begin to understand it.
Aggregation allows one to use the insights of Say's and Walras' Laws to discuss conditions of equilibrium. Our economy is more complex than the simple economy of Crusoe, Friday, and Saturday. Not only do we trade many thousands of goods and services, but we also exchange a complex array of debts and assets. Further, most people are not craftsmen or farmers producing and selling products, but are employees who sell their labor services in one of the many labor markets of the economy.
The central idea Say's Law is that if people plan or expect to receive a certain amount of income, they also have planned or expected uses. Thus a change in one market (such as the market for high school science teachers) will have affects in other markets (such as the markets for food and clothing). But tracing these effects from market to market is beyond the power of the human mind if we attempt to view the economy as made up of many thousands of markets. The solution has been to aggregate and create "composite" goods, so that we can picture the economy as made up of only a few markets.
There is no magic formula for the "right" amount of, or way to aggregate. Some theories imply a drastic aggregation to just two markets--we will see that both the quantity theory of money and the Keynesian multiplier model imply an aggregation to just two markets. However, economists usually prefer less aggregation. In modern market economies households do not barter but buy goods and services with money. Households have three ways to obtain the funds they use to finance these purchases. They can earn income by selling the services of their labor or other resources, they can borrow money or dissave, and they can reduce money balances. Usually the way economists aggregate reflects this list of sources and uses of funds.
The table below shows a way of aggregating that is useful for many discussions of macroeconomics. In this table all the millions of buyers and sellers have been grouped into only three categories: those in the private sector, the government, and the foreign sector. Often less aggregation is needed in the private sector. It can be separated into households and businesses, and sometimes the banking sector is split away from the rest of the business sector.
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Money |
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The markets in which people exchange have also been reduced in number, to a mere four. All goods and services are grouped together, and all labor markets and other resource markets are consolidated. All financial transactions, involving the purchase and sale of securities, are combined to form the financial market. Finally, to include the possibility both of changes in the amount of money circulating and the amount that people want to hold, a market for money balances is included.
There are no numbers included in the table. Entries are of planned or expected amounts, and there is no way of knowing these. The problems involved can be understood if one looks back to the supply and demand model. If a market is not in equilibrium, the desired amounts that buyers and sellers want to exchange are not equal, but the actual amounts that they do exchange are equal. Actual amounts can be observed, but they do not indicate if the market is or is not in equilibrium. Desired amounts, which would tell one whether or not the market was in equilibrium, cannot be directly observed. Thus, although one can get estimates of the actual amounts in each category in the table, they do not help in seeing which markets have excess supply and which have excess demand.
The table does, however, illustrate in a more general way the connections between sectors of the economy than does the approach of national income accounting, and can in fact show equation 5 of that discussion:
(5) (I - S) + (G + Transfers - Taxes) + (Xn - Tf) = 0.
To show equation 5, combine the goods and resources markets and consolidate the money market with the bond market. These changes plus a switch to actual transactions from planned transactions give us the table below. The actual (not planned) excess demand in the nonfinancial markets for the private sector is investment minus savings, for the government it is government expenditures minus taxes, and for the foreign sector it is net exports less foreign transfers. Because the actual values of these items are included, they must sum to zero both horizontally and vertically. The table indicates that excess demands in the nonfinancial markets will yield excess supplies in the financial markets, and vice versa.
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Nonfinancial Markets |
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Financial Markets |
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We end these readings with a claim that we are headed on the wrong path.
Copyright Robert Schenk
