Unit III: The AS-AD Model

Dr. Jayita Bit

Class 25
 The AS-AD Model versus
the IS-LM Model
• The AS-AD Model is not more complicated than the IS-LM
Model;
• IS-LM can only deal with the demand side of the economy. Any
increase in output is only an increase in aggregate demand;
• IS-LM cannot deal with important changes related to the supply
side of the economy, such as technological improvement,
population increase or capital accumulation;
• IS-LM cannot effectively deal with changes in general price level
in the economy (short-run assumption taken). It does not offer
insights on inflation;
• IS-LM works well only when wages and prices are rigid (or the
aggregate supply curve is horizontal);
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• AS-AD is a more complete model; III_Dr. Jayita Bit
 What happens in the ISLM model if
the price level is allowed to change?
• We had incorporated price only in the LM curve equation;
• !
r=(k.P/h).Y – 𝑀/h;
• Here, earlier we have taken P to be constant like k and h;
• But now we are considering P to change;
• Say, P rises from P1 to P2;
• Hence the slope of LM curve becomes more – steeper;
• LM curve rotates towards left;
• Then given IS curve, rate of interest rises and Y falls;
• This can be graphically shown as:

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 Relationship between IS-LM and AD (1)
Rate of
Interest LM(P2)

LM(P1)

r2

r1
IS

Y2 Y1 Output,
Figure 1 Y
• Thus, when P rises from P1 to P2, Y falls from Y1 to Y2;
• This inverse relationship between P and Y can be shown as:
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 Relationship between IS-LM and AD (2)
Price level, P

P2 A

P1 B

AD

Output, Y
Y2 Y1
Figure 2

• The Aggregate Demand (AD) curve describes a relationship between the

price level and the level of national income;
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 Why is the AD Curve Negatively Sloping?
• There is an important difference between the aggregate demand AD and the demand
curve for a specific good;
• The demand curve for apples relates the quantity demanded for apples to the price of
apples RELATIVE to the prices of other goods;
• While the AD Curve relates the aggregate quantity of output to the general price
level P;
• For any given level of money supply M, an increase in P implies that the real
supply of money M/P must go down.
• It becomes harder for people to borrow money, causing the price of loans, i.e.,
the interest rate r to go up.
• When interest increases, investment demand (and possibly consumption)
decreases. Thus, aggregate demand Y goes down.
• In terms of the equation: 𝑀 ! /P = k.Y – h.r/P;
• As P rises, in the LHS, 𝑀 ! /P falls; XAV_BCOM_MACRO_UNIT
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• If LHS falls, RHS also has to fall to maintain equilibrium;
• But in the RHS, h.r/P falls making RHS to increase;
• Hence Y must fall to maintain equilibrium;
• An increase in P can also create the so-called “real balance effect.”
• The resulting decline in M/P may lead people to believe that they are less wealthy;
• This further implies that they will reduce consumption. Thus, aggregate demand
goes down.
 Examples of Factors that Shift the AD
• Increase in government spending or decrease in taxes;
• As G rises or T falls, IS curve shifts towards right;
• Then given unchanged LM curve, output rises;
• Since there is no change in price level but there is change in output, hence AD
curve shifts towards right;

• Increase in M
• Real supply of money (M/P) goes up
• It becomes easier to borrow money
• Then interest rate goes down and output goes up;
• Graphically, LM curve shifts right expanding output without change in price
level;
• Since there is no change in price level but there is change in output, hence AD
curve shifts towards right;

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 Aggregate Supply AS
• The implications of the IS-LM framework are not different
from those of the AD curve. The more important addition is
the aggregate supply;
• AS is the relationship between the quantity of goods and
services supplied and the price level;
• Because the firms that supply goods and services have flexible
prices in the LR but sticky prices in the SR, the AS
relationship depends on the time horizon;

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 Long Run Aggregate Supply AS
• The classical model postulates that the AS curve is vertical, i.e., aggregate quantity
produced in the economy Y is independent of the price level P;
• They consider here the long-run time frame where price is fully flexible;
• Quantity supplied in an economy depends on labor employed, amount of capital
used, technological level, human capital (health, knowledge) of its workers,
efficiency in production, institutional support (such as good government or well-
defined property rights) and so on;
• Imagine that the government suddenly announces that from now on, a one rupee
note should be regarded as 10 rupees, and ten rupees should be taken as 100 rupees
and so on. The general price level P will go up by 10 times;
• However, nothing would happen to the output;
• Workers know that prices are 10 times higher, but their wage rates are also exactly
10 times higher. So, they will supply the same amount of labor, and therefore output
won’t change;

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 Shifting of AD
curve has no
impact on output
P2

AD’

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Difference between Long-run AS and Short-run AS
• In the previous diagrams, changes in AD cannot affect output.
This result is often regarded as a long-run phenomenon;
• It is often argued that in the short run, shifting of the AD curve
may still have some effects on output and price level;
• The short-run AS curve is postulated to be positively sloping;

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 The Sticky Wage Model
-Why nominal wages are sticky?
• The sticky wage model explains why the short-run aggregate supply curve is
sometimes upward sloping;
• According to the sticky wage model, the short-run aggregate supply curve is
upward sloping due to the sluggish adjustment of nominal wages;
• Why are nominal wages “sticky” in the short run?
• There are various reasons for this:
• 1. In many industries, the nominal wages are set by long-term contracts and so
the wages cannot adjust quickly when the economic conditions change;
• 2. In industries not covered by formal contracts, implicit agreements between
workers and firms may limit wage change;
• 3. Wages may depend on social norms and notions of fairness that evolve
slowly;

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 The Sticky Wage Model
-What happens to Aggregate Supply if nominal wages are sticky?

• If nominal wage (W) is fixed (W=𝑊),! then rise in price level (P) lowers Real
! falls);
wage (𝑊/P
• Labour becomes cheaper;
• Demand for labor increases (DL rises) – firms hire more labor (L increases);
• As labor demand is a negative function of real wage -> L=Ld (W/P);
• Additional labor produces more output (Y increases) as Y is a positive function
of L -> Y= F(L);
• Thus, given nominal wage, if price level rises, output rises;
• Thus, the aggregate supply curve, i.e., the relationship between P and Y is a
positively sloped curve;

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 The Sticky Wage Model
• Many economists believe that nominal wages are sticky in the short run.
W/P
When the nominal wage is stuck, a rise in P from P0 to
P1 lowers the real wage, making labour cheaper.

The lower real wage induces

firms to hire more labour. W/P0

W/P1 Ld
The positive relationship
between P and Y means AS The additional labour hired
slopes upward. produces more output. L0 L1 L

P Y

SRAS
Y1 Y=F(L)
P1
Y0
P0

Y L0 L1 L
Y0 Y1
 Equation of Aggregate Supply Curve
• Sticky Wage Model assumes that firms and workers negotiate contracts and fix the
nominal wage;
• The nominal wage, W, they set is the product of a target real wage, w, and the
expected price level:
e
W = ω ´P
• Thus, real wage:
W Pe
=ω´
P P
• If Pe is equal to P, then W/P = 𝜔 ; then firms will neither hire more nor less workers
and hence output will remain same at its natural level (Y = 𝑌" );
• If Pe is less than P, Real wage is less than its target, so firms hire more workers and
output rises above its natural rate (Y > 𝑌" );
• If Pe is more than P, Real wage exceeds its target, so firms hire fewer workers and
output falls below its natural rate (Y < 𝑌" );
• Thus, the difference between P and Pe is directly related to the difference between
Y and 𝒀 $;
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 Equation of Aggregate Supply Curve
• It can be expressed as: Y = Y + a ( P - P e )
• Where P-Pe shows the unexpected change in price level;
• Y- 𝑌" shows the change in output or the deviation of output from the natural level;
• ⍺ (⍺>0) be the parameter that indicates how much output responds to unexpected
changes in price level;
• Changes in Y depends on changes in real wage (W/P);
• W/P again depends on Pe/P; P
• So, changes in Y depends on the values of P /P;
e SRAS

• "
If Pe=P, Y= 𝑌;
• If Pe≠ P, Y deviates from 𝑌" ;
• That is, output deviates from its natural level;
% 𝒀
𝜶𝑷𝒆 $𝒀
• Interchanging P and Y, we get: 𝑷 = + ; 𝜶𝑷𝒆 − 𝒀%
𝜶 𝜶
𝜶
%
𝜶𝑷𝒆 $𝒀
• Then, slope is 1/⍺ and y-intercept is: ;
𝜶 Y
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 Short-run and long-run AS Curves

P
LRAS

SRAS2

C
𝑃3 = 𝑃$" SRAS1
B
P2
P1= 𝑃!" = 𝑃#"
A
AD2
AD1

Y1=Yn Y2 Y

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 Transition from SR to LR equilibrium when AD increases
• The economy initially attains equilibrium at A, where both long-run and short-run equilibrium is
achieved;
• And since long-run equilibrium is there, so, at A, expectation has been realized;
• So, actual price P1=expected price 𝑃'( ;
• And the the equilibrium level of output is the ‘full employment’ or ‘Natural Rate of Output’, i.e., Y1=Yn;
• Now, suddenly if there is any change in demand, say, increase in AD, because of increase in money
supply, AD shifts right to AD2;
• And instantly, equilibrium is attained at the intersection of SRAS1 and AD2 (i.e. at B);
• Consequently, Y increases to Y2 (Y2>Yn) and actual price level rises to P2;
• However, people have not expected price to rise to P2;
• So, expected price level remains at P1. So, P1= 𝑃'( = 𝑃)( ;
• But with time, people will expect price to rise;
• So, the expected price level will rise – rise above P2 to 𝑃*( ;
• Thus, workers will also revise their expectation of price level, W = 𝜔 x Pe ( );
• As Pe rises, since W is sticky, so 𝜔 has to fall but trade unions will not allow that;
• So, W has to rise;
• Then, W/P rises and Ld falls giving rise to less employment of labor and hence Y falls;
• This goes on till Y=Yn;
• So there will be shift in the SRAS curve from SRAS1 to SRAS2;
• And the new equilibrium is obtained at point C, where the economy returns to a new LR equilibrium and
output is back at its natural rate and also price expectations are realized;
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