AD-AS model

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The AD-AS or Aggregate Demand-Aggregate Supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply. It was first put forth by John Maynard Keynes in his work The General Theory of Employment, Interest, and Money. It is the foundation for the modern field of macroeconomics, and is accepted by a broad array of economists, from Libertarian, Monetarist supporters of laissez-faire, such as Milton Friedman to Socialist, Post-Keynesian supporters of economic interventionism, such as Joan Robinson.

Modeling

The AD/AS model can be used to demonstrate two significant macroeconomic events; the Phillips Curve relationship, and stagflation.

The Phillips Curve shows the relationship between changes in price (inflation) and unemployment. This relationship is fundamental to Keynesian Economics because changes in the money supply are seen to be non-neutral.

To model the Phillips Curve using the AD/AS model, a rightward shift in the AD curve is shown. This demonstrates how Aggregate Demand side managers such as the federal government and the monetary authority are able to throttle the economy, opting for either high inflation with low unemployment, or high unemployment with low inflation. However, the Phillips Curve was shattered during the 1970s oil crisis, with oil prices constituting a cost shock that shifted the AS curve to the left. (Previously, the Phillips Curve had been assuming that the AS curve stays pretty much constant, with only the AD curve shifting right or left based on economic growth.) The phenomenon in macroeconomics of stagflation was being witnessed: stagnant growth with high inflation. Policy makers were helpless to do anything because they can only affect Aggregate Demand, not Aggregate Supply. The Phillips Curve was done away with and policy makers were at a loss.

The Federal Reserve Governor at the time Arthur F. Burns attempted to solve the problem. He was seen as dovish on inflation and preferred keeping the economy at full employment. He pursued a "loose" monetary policy and increased the money supply. Some today now contest Mr. Burns actions because had the oil shock been a permanent shock to supply thus shifting the LRAS curve left, he only made the situation worse by keeping us at a higher rate of inflation. His policy was quite different from two Fed Chairmans later Paul A. Volcker, who is seen as the most hawkish governor of all times.

AD curve

The AD curve is defined by the IS-LM-FE model (Mundell-Fleming model) equilibrium income at different price levels. The equation for the AD curve for flexible exchange rates is:

p = m − bY + h(i^W + ε^e)

The equation for the AD curve for fixed exchange rates is:

p = e + p^W − bY + γY^W + δG − f(i^W + ε^e)

AS curve

The AS curve is defined by the labour market equilibrium at different price levels. Since the equilibrium in the labour market stays the same at different price levels in the long run, the LAS curve is a vertical line at equilibrium income. In the short run, the AS curve turns clockwise because the labour market can't react to surprises immediately. The equation for the short run AS curve is:

p = p^e + λ(Y − Y * )

See also

• IS/LM model
• AD-IA Model
• DAD-SAS model

External links

• Sparknotes: Aggregate Supply and Aggregate Demand brief explanation of the AD-AS model
• "Aggregate Demand and Aggregate Supply" in CyberEconomics by Robert Schenk explains the AD-AS model and explains its relation to the IS/LM model
• "ThinkEconomics: Macroeconomic Phenomena in the AD/AS Model" includes an interactive graph demonstrating inflationary changes in a graph based on the AD-AS model
• "ThinkEconomics: The Aggregate Demand and Aggregate Supply Model" includes an interactive AD-AS graph that tests one's knowledge of how the AD and AS curves shift under different conditions

Scholarly articles

• Dutt, Amitava K.and Skott, Peter. "Keynesian Theory and the AD-AS Framework: A Reconsideration," Working Papers 2005-11, University of Massachusetts Amherst, Department of Economics. 2005.
• Palley, Thomas I. "Keynesian theory and AS/AD analysis". Eastern Economic Journal, Fall 1997.
• Amitava Krishna Dutt and Skott, Peter. "Keynesian Theory and the Aggregate-Supply/Aggregate-Demand Framework: A Defense," Eastern Economic Journal, Eastern Economic Association, vol. 22(3), pages 313-331, Summer 1996.