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## The AS-AD-model## Introduction## The problem with the IS-LM modelThe starting point of the AS-AD model is an assumption in the IS-LM model (and in the cross model) that (L T), they would produce more than the aggregate demand. In the IS-LM, YOPT > L must hold as discussed in section 11.4.3.YD To realize why this is a problem in the IS-LM model, we gradually increase the aggregate demand by increasing G. We can illustrate the process using figure 12.6 in Section 12.5.
1. Let us begin with a given real wage = Y0 and Y = L0.L 2. Now increase just enough so that G = Y in equilibrium, i.e. exactly to the level that firms want to produce at the given real wage.YOPT 3. Firms will now want to hire 4. Now imagine that we increase = Y2 > Y Now the IS-LM model is in trouble.YQpT. 5. According to the production function, to produce = L2. L (which is assumed in the IS-LM model). But firms will only hire LOPT if the real wage is constant is the profit maximizing quantity - to produce more would reduce profits.LOPT 6. As firms will not hire more than in the IS-LM model. This model simply cannot give an answer to what will happen when we increase YOPT in step 4 since we would be violating one of the main assumptions of the IS-LM model.G This problem is not limited to changes in and shift the LM-curve. If we shift the LM-curve to the right by an amount such thatMS
the IS-LM model cannot be used.YOPT, The IS-LM model is not "wrong", but Generally, the IS-LM model will perform reasonable as long as the price level is stable (low inflation) and it will do better in a recession than in a boom.YOPr ## How the AS-AD model solves the problemThe purpose of the AS-AD model is to extend the IS-LM model so that we can analyze situations where
To accomplish this, we must make YOPr endogenous in the AS-AD model. When P is endogenous and allowed to vary, real wage P may vary even if the nominal wage W/P is fixed. The AS-AD model, therefore, maintains the assumption of fixed and exogenous nominal wages W. This is consistent with "The General Theory of Employment, Interest and Money" by John Maynard Keynes in which he quite vigorously argue that "wages tend to be sticky in terms of money" while real wages will not be as stable (see chapter 17 in the General Theory).W When may fall and with a lower real wage, labor demand will increase and so will GDP (as long as there is sufficient demand). By making W/P endogenous, we can allow for P to be greater than Y YOPT.## The assumptions of the AS-AD model## SummaryThe most important change we make going from the IS-LM model to the AS-AD model is to allow to be endogenous. Here is a summary of the changes that must be made and what will not change:P • Even if is therefore still equal to the nominal interest rate r R.• There is no change in the aggregate demand, + I(R) + C(Y) + G - X None of the components will be a function of Im(Y). for given values of P and Y R.• on positively in AS-AD model. In the AS-AD model, the demand for money is given by P still depends positively on MD(Y, R, P). MD and negatively on Y R.• Aggregate supply will be more complicated. In the IS-LM model, aggregate supply was simply equal to aggregate demand but this is no longer the case in the AS-AD model. • Since real wages are no longer constant, we must make a more detailed analysis of the labor market. ## The AS-AD model and inflationEven though the AS-AD permits changes in the price level, There will of course be periods with inflation/deflation in the model as prices change but inflation/ deflation must disappear when the economy reaches a new equilibrium. In the next chapter, we remove the assumption of fixed nominal wages and the model will then allow for persistent inflation. |

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