The problem with the IS-LM model
The starting point of the AS-AD model is an assumption in the IS-LM model (and in the cross model) that limits its usefulness. This is the assumption that if firms where to choose the profit maximizing quantity of L (L T), they would produce more than the aggregate demand. In the IS-LM, YOPT > YD must hold as discussed in section 11.4.3.
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.
Fig. 13.1: Illustrating the problem in the IS-LM model
1. Let us begin with a given real wage W/P, an IS curve (IS0) and an LM curve. In equilibrium, we will have Y = Y0 and L = L0.
2. Now increase G so that IS curve shifts outwards from IS0 to IS1. In the first step, we increase G just enough so that Y = YOPT in equilibrium, i.e. exactly to the level that firms want to produce at the given real wage.
3. Firms will now want to hire LOPT which is precisely the profit-maximizing quantity of L. It is no longer necessary for firms to hire less than the profit maximizing quantity as there is no longer a shortage in aggregate demand. So far, no problems in the IS-LM model.
4. Now imagine that we increase G even more so that the IS curve shifts to IS2 such that so that Y = Y2 > YQpT. Now the IS-LM model is in trouble.
5. According to the production function, to produce Y = Y2 we need L = L2. But firms will only hire LOPT if the real wage is constant (which is assumed in the IS-LM model). LOPT is the profit maximizing quantity - to produce more would reduce profits.
6. As firms will not hire more than LOPT if real wages are constant, GDP cannot be larger than of YOPT in the IS-LM model. This model simply cannot give an answer to what will happen when we increase G in step 4 since we would be violating one of the main assumptions of the IS-LM model.
This problem is not limited to changes in G and shifts in the IS-curve. The same problem appears when we change MS and shift the LM-curve. If we shift the LM-curve to the right by an amount such that
Y > YOPT, the IS-LM model cannot be used.
The IS-LM model is not "wrong", but it is applicable only as long as Y > YOPr 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.
How the AS-AD model solves the problem
The purpose of the AS-AD model is to extend the IS-LM model so that we can analyze situations where
Y > YOPr To accomplish this, we must make P endogenous in the AS-AD model. When P is endogenous and allowed to vary, real wage W/P may vary even if the nominal wage W 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).
When P is allowed to increase, real wage W/P 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 P endogenous, we can allow for Y to be greater than YOPT.
The assumptions of the AS-AD model
The most important change we make going from the IS-LM model to the AS-AD model is to allow P to be endogenous. Since P was constant in the IS-LM model, we must "redo" the IS-LM model allowing P to be endogenous. Here is a summary of the changes that must be made and what will not change:
• Even if P is endogenous, we still assume that the expected inflation is 0. The real interest rate r is therefore still equal to the nominal interest rate R.
• There is no change in the aggregate demand, YD(Y, R) = C(Y) + I(R) + G + X - Im(Y). None of the components will be a function of P for given values of Y and R.
• MD will depend positively on P in AS-AD model. In the AS-AD model, the demand for money is given by MD(Y, R, P). MD still depends positively on Y and negatively on 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 inflation
Even though the AS-AD permits changes in the price level, it does not allow for persistent inflation or deflation. We cannot have continued increases or decreases in the price level if nominal wages are to be constant since this would lead to continued decreases or increases in the real wages which does not make sense (remember that we have removed growth when we do the analysis).
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.