AD–AS model

The AS- AD model is a model of the macro economy and describes the macroeconomic equilibrium in the closed economy to a medium- long term. The AS- AD model to describe the overall economic impact of governmental and fiscal policies on wages, the price level and production. The model consists of the portion of the aggregate bid ( AS: English: " aggregate supply " ) to the neoclassical approach, and the part of aggregate demand (AD: "aggregate demand" ) by John Maynard Keynes together. The synthesis was developed principally by contributions from Hicks in 1937 and Modigliani 1944.

• 6.1 AD curve
• 6.2 AS curve

History

In 1936, John Maynard Keynes published "The General Theory of Employment, Interest and Money". In this work he criticized the then prevailing opinion about a full employment in the labor market. So he questioned whether an equilibrium is set on the labor market. Furthermore, Keynes came from wage rigidities, which means that wages are at least not in the short term adjust to the labor market equilibrium. Thus Keynes attacked the assumption that wage flexibility rule.

The theories of Keynes was the neoclassical view towards which has evolved from the classical approaches of Adam Smith, David Ricardo, and other authors. Important representatives of neoclassicism were, among others, William Stanley Jevons, Carl Menger, and Léon Walras. According to the neoclassical model of Walras prevail in the markets flexible prices and perfect foresight, that is, that any operator can accurately determine what is the best economical solution in terms of wealth distribution for the entire market. In addition, according to Walras no adjustment processes take place, as an exchange process only takes place when the equilibrium prices are fixed.

By combining the Keynesian view on the money and goods market as well as the neoclassical assumptions on the labor market developed authors, such as 1944, Franco Modigliani, first descriptions of an aggregate supply and an aggregate demand.

AS- AD model as an extension of the IS -LM model

While the IS- LM model only goods market and money market are in equilibrium, the AS- AD model relates an equilibrium in the labor market with. The model assumes that a natural rate of unemployment exists that sets the medium term. Only when the actual unemployment rate of natural unemployment corresponds (also structural unemployment ), the labor market is in equilibrium.

In addition to flow, one unlike the IS- LM model, and changes in the price level in the model with consideration. In the IS- LM model, the prices are treated as givens, which means that a change in the demand for goods always leads to a corresponding change in the quantity of goods produced. The AS- AD model shows how different measures, for example, an expansionary monetary policy could affect an economy. The AS- AD model also shows that an economy is not steady in growth, but that there are periods each with different growth rates. The relationship between the AS- AD and IS- LM model consists firstly in the fact that the AD curve is derived from the IS- LM model and, secondly, that the impact of price changes can be described on the money and goods market.

Composition of aggregate supply and aggregate demand

The aggregate supply and thus the aggregate supply curve shows at any given price level, the quantity that want to offer the company.

In the medium term, ie, the time of observation, in which the AS - AD model attaches to the supply curve is in transition from the short term in the long term. In the short run, the supply curve is horizontal to the classical theory, as can be expected in the short term from the fact that the prices are not changeable. In the long run it is vertical, that is, prices are flexible. This has the consequence that the supply curve has a positive slope in the medium term.

The aggregate demand curve shows the combination of the price level and the amount at which goods and money markets are in equilibrium. This is the point of intersection of the IS and the LM function, the IS- LM model.

The IS function that describes an equilibrium in the goods market results when the amount produced with demand. The LM function shows that a balance on money and financial fields if the money supply equal to money demand. This must be the real money supply, ie the equivalent in goods, money supply, consistent with the real income.

Adjustment mechanism in the transition from the short to the medium term

In the short term can vary the production of its natural level, since a change of a variable from AS or AD function leads to a change in the price and production levels. In the medium term, production will, however, always return to their natural level. It adapts with changes in price expectations and this triggered consequences for actual price levels and production.

The following process takes place, for example, the transition should be considered short to medium term, assuming that the actual level of production is higher than the natural level of production ( see Figure "The starting point of the adjustment in the AS- AD model " ) The natural level of output is the level is produced on if the employment is the natural level of employment. The natural level of employment is the level that results when subtracting the natural rate of unemployment on the number of labor force.

• The starting point of the actual production ( denoted by Y ) is above the natural production (Yn ). In this case also corresponds to the expected price level ( Pe ) is not the actual price level ( P). The expected price level is lower.
• In the first step ( see Figure " First step of the adjustment in the AS- AD model " ) then the increase in the wage-setting participants their price expectations on the actual price level, as under the assumption that the production level is above the natural level of output, the past Price expectancy was lower than the actual price level. Thus, the AS curve will shift upward because an increase in production can increase employment, lowering the unemployment decreases and thus improved the bargaining position of workers. This then leads to an increase in nominal wages, which is reflected in a more expensive production and thus reflected in a higher price level. This displacement has been a reduction in the money supply, since an increase in the price level causes this effect on the money market. This reduction in the money supply leads to higher interest rates, because now a process of adjustment in the money market takes place, which leads to a shift of the LM curve ( In an open economy, this process is also reinforced by a rise in the real exchange rate and hence a deterioration of net exports also ). This also means that a new equilibrium is established on the money and goods market, which then describes a lower production.
• By displacement in the first step, the natural level of production is, however, not yet been achieved. This process will be repeated until the production has fallen back to its natural level. This also corresponds to the expected price level back to the actual price level ( see Figure " Second Step of adjustment in the AS- AD model ").

Impact on the AS- AD model with variables change

Subsequently, the effects of the changes of variables from the IS- LM model and from the labor market model and consequences of external influences, so-called shocks considered.

Monetary policy

Increases the money supply, this lowers the short term the interest rate on the money market in the IS- LM model, assuming that the production before increasing the natural level corresponded ( see Figure " adjustment process in the AS- AD model with expansionary monetary policy " ). This increases production and the price level. The increase in production is initially higher than the increase in the price level. However, this effect is reversed, so that the increase in the money supply in the medium leads to an equal increase in the price level and no change in the production. It is in this case the neutrality of money.

This result is achieved by the following adjustment process. Any increase in the nominal money supply in the IS- LM model, then so also increases the real money supply at a given price level initially. This increases according to the properties of the IS- LM- model production. This leads to the fact that the aggregate demand curve shifts to the right. Through this shift, the production is in balance, but above their natural level and is thus also the actual price levels above the price level, which is the expected to the wage-setting participants. These will now adjust their price expectations upwards, so that the aggregate supply curve will shift upward and there is a movement along the AD curve. This process will continue until the production has reached back to its natural level, with the result that production has not changed in the medium term, the price level, however, the increase in money supply is increased accordingly.

Fiscal policy

Reduces the state its expenditure, this initially leads to a fall in output. In the further course of time, however, the production increased again and there is a lower price level ( see illustration: " adjustment process in the AS- AD model with restrictive fiscal policy ").

This is the result perform the following steps, assuming that the production has held prior to the fiscal encroachment on their natural level. The reduction of government spending, the AD curve shifts to the left because the aggregate demand curve represents an equilibrium in the goods and money markets. This balance will change when the production falls. The production is no longer in this case is its natural level. In the further course of time the production will be according to the above-mentioned process of adjustment, adjust again its natural level, because in this case the actual price levels below the expected price level is and will adjust their expectations accordingly to the wage-setting participants. In this case, there is movement along the aggregate demand curve until it intersects again with the adjusted aggregate supply curve. The production is thus returned to their natural level.

Shocks

Negative shocks, such as a dramatic increase in oil prices, may lead to an increase in the price level and a fall in production ( see figure " of possible adjustment process in the AS- AD model with a shock" ).

This conclusion is reached by the following considerations, which address only the effects on the AS curve, as it is assumed for simplicity that the AD curve does not change. An increase in the price of oil can flow into the considerations of the AS -AD model characterized by the profit markup factor μ is increased accordingly in consideration of the labor market. This increase in the price-setting straight shifts in the labor market, ie the real wage of workers is lower than before. Thus, this reduction in the real wage is accepted by the workers, a higher natural rate of unemployment, or a lower natural level of employment is required. If it is assumed that an employee is responsible for the production of a unit of production exactly necessary, decreases by the reduction in the natural level of employment and the natural level of output.

Based on the above adjustment process in the labor market and the corresponding consequences for the AS -AD model, the current level of production is therefore in such a negative shock to the natural level of output. Thus, a process of adaptation is taking place again in the AS- AD model until production has returned to its natural level.

Mathematical derivation

The derivation of the AS -AD model is based on the IS- LM model ( equilibrium in the money market and the goods market ) and the labor market equilibrium, since it can be derived from these two equilibrium conditions.

AD curve

The AS- AD model performs the assumptions of the IS- LM model in the AD curve, ie the aggregate demand to continue and also reacts to changes of variables from this model. Thus, the AS- AD model assumes an equilibrium in the goods and money market in order to derive the AD curve. An equilibrium in the goods and money market corresponding to each point on the AD curve. The AD curve will therefore comprise the variables of the goods market, such as consumer spending, investment spending, and government spending and the variables of the money market, such as price level and interest rate, together.

First, the IS curve will be dissolved upon the interest rate i.

Here, Y describes the demand for goods, C is the consumption expenditure of households, I, the business investment and G is the government expenditure. The investments I have this depends on the demand for goods and the interest rate i

Then, the LM curve is solved for the price level, where M is the nominal money supply, P reflect the price level and the interest rate i.

AD - curve formed by the insertion of the IS- curve (1) in the LM curve (2).

AS curve

The AS curve has its origin in the labor market. The components of the labor market are the WS curve ( wage setting ) and the PS- curve (price setting ). The PS curve, which describes the prices is independently considered in the following as income. It runs horizontally so. Prerequisite for this are constant marginal costs.

One possible version of the price-setting equation is:

Here P stands for the price level, μ for a profit impact of the company on their incurred costs, and W for the aggregate nominal wage, ie the amount that an average worker gets paid at the end of the month.

One possible version of the wage-setting equation is:

This represents the expected price level, u for the unemployment rate and z is a collective variable, in which all other variables are summarized, which can affect the wage setting.

By equating the WS curve ( 2 ) and PS - curve (1), creates the AS curve.

The factor describes the expected price level. Since wages rarely respond immediately to a change in the price level, calculate social partners with an estimated inflation rate. Only if the expected inflation correspond to the actual, the labor market is in equilibrium. The production level corresponds to the natural level of output. The economic theory assumes that this equilibrium is established in the medium term, provided that all other conditions remain unchanged.

The AS curve was first discovered by the British economist Alban William Phillips. He introduced his model, the Phillips curve, starting from empirical observations. The AS- AD model, however, was formulated later.

Criticism

The critical reception of the basic concept started in 1938 by Dunlop and Tarshis by 1939. Both authors emphasized the lack of empirical foundation.

The AS and the AD curve have a different course depending on the approach used. The AS curve is horizontal in the classical approach. In contrast, it runs in the extreme keynesisanischen case, ie when wage rigidity, vertical. Due to this difference of opinion arises interpretation of diversity, as for example, the consequences of government intervention may be different.

AD - derived curve may be also different. Thus, some authors assume that this is derived from the aggregation of micro-economic equilibria on individual markets. Mostly you will find, however, the interpretation of the AD curve as the derivative of the money and goods market equilibrium, ie the intersection of the IS- LM curve in the IS- LM model.

Note also that in the AS- AD model shown here external relations found any attention. Important external elements, such as changes in exchange rates could change the course of the curves and thus it may be necessary to take other measures to stabilize the economy.

The AS- AD model also shows that the use of only one measure, so each government or monetary policy intervention, rarely to achieve the macroeconomic objectives contributes. It is usually a combined use of supply-side and demand-side instruments required. If, for example, only an expansionary monetary policy, it also leads to an increase in the production level, but at an increased price level.