AD-AS model
Encyclopedia
The AD-AS or Aggregate Demand-Aggregate Supply model is a macroeconomic model that explains price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

 and output
Output (economics)
Output in economics is the "quantity of goods or services produced in a given time period, by a firm, industry, or country," whether consumed or used for further production.The concept of national output is absolutely essential in the field of macroeconomics...

 through the relationship of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 and aggregate supply
Aggregate supply
In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period...

. It is based on the theory of John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

 presented in his work The General Theory of Employment, Interest, and Money. It is one of the primary simplified representations in the modern field of macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, and is used by a broad array of economists, from libertarian
Libertarianism
Libertarianism, in the strictest sense, is the political philosophy that holds individual liberty as the basic moral principle of society. In the broadest sense, it is any political philosophy which approximates this view...

, Monetarist supporters of laissez-faire
Laissez-faire
In economics, laissez-faire describes an environment in which transactions between private parties are free from state intervention, including restrictive regulations, taxes, tariffs and enforced monopolies....

, such as Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

 to Post-Keynesian
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...

 supporters of economic interventionism
Economic interventionism
Economic interventionism is an action taken by a government in a market economy or market-oriented mixed economy, beyond the basic regulation of fraud and enforcement of contracts, in an effort to affect its own economy...

, such as Joan Robinson
Joan Robinson
Joan Violet Robinson FBA was a post-Keynesian economist who was well known for her knowledge of monetary economics and wide-ranging contributions to economic theory...

.

The conventional "aggregate supply and demand" model is, in actuality, a Keynesian visualization that has come to be a widely accepted image of the theory. The Classical supply and demand model, which is largely based on Say's Law
Say's law
Say's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...

, or that supply creates its own demand, depicts the aggregate supply curve as being vertical at all times (not just in the long-run)

Modeling

The AD/AS model is used to illustrate the Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 model of the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

. Movements of the two curves can be used to predict the effects that various exogenous events will have on two variables: real GDP and the price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

. Furthermore, the model can be incorporated as a component in any of a variety of dynamic models (models of how variables like the price level and others evolve over time). The AD-AS model can be related to the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

 model of wage or price inflation and unemployment.

Aggregate demand curve

The AD curve is defined by the IS-LM equilibrium income at different potential price levels.
The Aggregate demand curve AD, which is downward sloping, is derived from the IS – LM model.
It shows the combinations of the price level and level of the output at which the goods and assets markets are simultaneously in equilibrium.
The above figure showing IS and LM curves, where LM curve shifts downward to the right to LM’ and thus shifting the new equilibrium to E’ where both goods and money market gets cleared. Now, the new output level Y’ correspond to the lower price level P’.
Thus a reduction in price, which is shown in the figure, leads to an increase in the equilibrium and spending.

The equation for the AD curve in general terms is:


where Y is real GDP, M is the nominal money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, G is real government spending
Government spending
Government spending includes all government consumption, investment but excludes transfer payments made by a state. Government acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community is classed as government final...

, T is an exogenous component of real taxes levied, P is the price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

, and Z1 is a vector of other exogenous variables that affect the location of the IS curve (exogenous influences on any component of spending) or the LM curve (exogenous influences on money demand). The real money supply has a positive effect on aggregate demand, as does real government spending (meaning that when the independent variable changes in one direction, aggregate demand changes in the same direction); the exogenous component of taxes has a negative effect on it.

Slope of AD curve

The slope of AD curve reflects the extent to which the real balances change the equilibrium level of spending, taking both assets and goods markets into consideration.
An increase in real balances will lead to a larger increase in equilibrium income and spending, the smaller the interest responsiveness of money demand and the higher the interest responsiveness of investment demand.
An increase in real balances leads to a larger level of income and spending, the larger the value of multiplier and the smaller the income response of money demand.

This implies that:
The AD curve is flatter, smaller is the interest responsiveness of the demand for money and larger is the interest responsiveness of investment demand.
Also, the AD curve is flatter, the larger is the multiplier and the smaller the income responsiveness of the demand for money.

Effect of Monetary Expansion on the AD curve

An increase in the nominal money stock leads to a higher real money stock at each level of prices. In the asset market, the decrease in interest rates induces the public to hold higher real balances. It stimulates the aggregate demand and thereby increases the equilibrium level of income and spending.Thus, as we can see from the diagram, the aggregate demand curve shifts rightward in case of a monetary expansion.

Aggregate supply curve

The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium. In either case, it shows how much output is supplied by firms at various potential price levels.
The Aggregate supply curve (AS curve) describes for each given price level, the quantity of output the firms are willing to supply.

The Keynesian case shows that the AS curve is horizontal implying that the firm will supply whatever amount of goods is demanded at a particular price level.
The idea behind that is because there is unemployment; the firms can get as much labour as they want at that current wage. Their average costs of production therefore are assumed not to change as their output level change. They are thus willing to supply as much as is demanded at the existing price level.
The Classical Supply Curve is based on the assumption that the labour market is always in equilibrium with the full employment of the labour force. If the entire labour force is being employed, then output can’t be raised even if the price rises as there is no extra labour force for extra output. Thus, the AS curve will be vertical at the level of output corresponding to the full employment of the labour force.

Fiscal and monetary policy under Classical and Keynesian cases

Keynesian Case:
If there is a fiscal expansion i.e. there is an increase in the government spending or a cut in the taxes, it will shift the AD curve rightwards. The shift would then imply an increase in the equilibrium output and employment.

In the Classical case, the AS curve is vertical at the full employment level of output. Firms will supply the equilibrium level of output whatever the price level maybe.

Now, the fiscal expansion shifts the AD curve rightwards, thus leading to an increase in the demand for goods, but the firms cannot increase the output as there is no labour force which can be obtained.
As firms try to hire more labour, they bid up wages and their costs of production and thus they charge higher prices for the output.
The increase in prices reduces the real money stock and leads to an increase in the interest rates and reduction in spending.

The equation for the aggregate supply curve in general terms for the case of excess supply in the labor market, called the short-run aggregate supply curve, is

where W is the nominal wage rate (exogenous due to stickiness in the short run), Pe is the anticipated (expected) price level, and Z2 is a vector of exogenous variables that can affect the position of the labor demand curve (the capital stock or the current state of technological knowledge). The real wage has a negative effect on firms' employment of labor and hence on aggregate supply. The price level relative to its expected level has a positive effect on aggregate supply because of firms' mistakes in production plans due to mis-predictions of prices.

The long-run aggregate supply curve refers not to a time frame in which the capital stock is free to be set optimally (as would be the terminology in the micro-economic theory of the firm), but rather to a time frame in which wages are free to adjust in order to equilibrate the labor market and in which price anticipations are accurate. In this case the nominal wage rate is endogenous and so does not appear as an independent variable in the aggregate supply equation. The long-run aggregate supply equation is simply

and is vertical at the full-employment level of output. In this long-run case, Z2 also includes factors affecting the position of the labor supply curve (such as population), since in labor market equilibrium the location of labor supply affects the labor market outcome.

Shifts of aggregate demand and aggregate supply

The following summarizes the exogenous events that could shift the aggregate supply or aggregate demand curve to the right. Of course, exogenous events happening in the opposite direction would shift the relevant curve in the opposite direction.

Shifts of aggregate demand

The following exogenous events would shift the aggregate demand curve to the right. As a result, the price level would go up. In addition if the time frame of analysis is the short run, so the aggregate supply curve is upward sloping rather than vertical, real output would go up; but in the long run with aggregate supply vertical at full employment, real output would remain unchanged.

Aggregate demand shifts emanating from the IS curve:
  • An exogenous increase in consumer spending
  • An exogenous increase in investment spending on physical capital
    Physical capital
    In economics, physical capital or just 'capital' refers to any already-manufactured asset that is applied in production, such as machinery, buildings, or vehicles. In economic theory, physical capital is one of the three primary factors of production, also known as inputs in the production function...

  • An exogenous increase in intended inventory investment
  • An exogenous increase in government spending on goods and services
  • An exogenous increase in transfer payments from the government to the people
  • An exogenous decrease in taxes levied
  • An exogenous increase in purchases of the country's exports by people in other countries
  • An exogenous decrease in imports from other countries


Aggregate demand shifts emanating from the LM curve:
  • An exogenous increase in the nominal money supply
  • An exogenous decrease in the demand for money (in liquidity preference)

Shifts of aggregate supply

The following exogenous events would shift the short-run aggregate supply curve to the right. As a result, the price level would drop and real GDP would increase.
  • An exogenous decrease in the wage rate
  • An increase in the physical capital stock
  • Technological progress — improvements in our knowledge of how to transform capital and labor into output


The following events would shift the long-run aggregate supply curve to the right:
  • An increase in population
  • An increase in the physical capital stock
  • Technological progress

Monetarism

The modern quantity theory states that the price level is proportional to the quantity of money. Only a few believe this as it is an old concept.
Friedman is the recognized intellectual leader of an influential group of economists, called, Monetarists, who emphasize the role of money and monetary policy in affecting the behaviour of output and prices.
Modern quantity theory also disagrees with the strict quantity theory in not believing that the supply curve is vertical in the short run.
Thus, Friedman and other monetarists made an important distinction between the short run and long run effects of changes in money. They said that in the long run money is more or less neutral. Changes in real money stock have no real effects and only change prices. But in the short run, they argue that the monetary policy and changes in the money stock can have important real effects.

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