Aggregate supply

In order to determine all the variables in the AS-AD model, we need one more equilibrium condition so that we can identify a unique point on the AD curve as the unique equilibrium. This condition will come from the production side and the labor market.

The Labor Market

In the AS-AD model, the economy will always be on the response curve - the thick line in the chart below.

Fig. 13.6: The labor in the AS-AD model.

The response curve has a horizontal part and a downward sloping part. In the IS-LM model, we had only the horizontal since real wages where constant. We could not move beyond LB.

We can explain the response curve by examining the economy moving from point A to point C.

• First, the economy is at point A, with prices P, wages W, real wages W/P and amount of labor LA. The profit-maximizing quantity of labor is LB but firms do not choose this quantity due to lack of demand.

• If aggregate demand increases, L may increase without P being affected, up to L = LB. To the left of point B, the IS-LM model is fully sufficient and the AS-AD model is redundant.

• When L = LB, L cannot increase without real wages falling. In the AS-AD model, real wages are reduced by an increase in P (with W constant) and we begin to move down the demand curve for labor.

• Between the points B and C, L will increase when P increases.

• However, we cannot increase L above LC. When we are at point C, not even a price increase will help. Real wages are no so low that the labor supply sets the limit - there are no more people that want to work for these low real wages.

Let us summarize:

• As long as L is smaller than LB, L may change with no change in prices. In this range, there is no relation between P and L.

• When L is between LB and LC, then L increases with P.

• L can never be greater than the LC.

The chart below shows the relationship between L and P

Fig. 13.7: The relationship between L and P.

Aggregate supply and the AS curve

The AS curve is the aggregate supply as a function of P. It is horizontal when the supply is low and upward sloping when the supply is high.

From the relationship between L and P we can derive the relationship between YS and P as YS is determined by L by the production function (the higher L, the higher the ).

Fig. 13.8: The relationship between YS and P.

Between points A and B prices are constant and firms produce an amount exactly equal to the aggregate demand. Here, the reversed Say’s Law and the IS-LM model apply. In this interval, the AS-AD model is redundant. Between points B and C we have a positive relation between P and YS. Neither the reversed Say’s Law nor the IS-LM model apply.

It is, however, unreasonable to believe that there would be a "sharp edge" in the relationship between L and P and between YS and P in the real economy. The schedules are drawn this way to simplify the explanation. A more reasonable assumption would be that the relationships are smooth curves.

Fig. 13.9: More realistic relationships between L and P and between YS and P.

Determination of all the endogenous variables in the AS-AD model

Determination of P and Y

Prices and GDP are in equilibrium when aggregate supply is equal to the aggregate demand in the AS-AD model

We know that for all points on the AD curve, both the goods and money market are in equilibrium. We also know that firms will always produce an amount consistent with the AS-curve.

Fig. 13.10: Determination of P and Y in the AS-AD model.

There is only one level for P and for Y which is consistent with equilibrium in both markets and which is consistent with firm behavior. The price level at this point is the equilibrium price level and the GDP level at this point is the equilibrium quantity of GDP. We denote these levels by P* and Y*.

The AS-AD model, P will always move towards P* and Y will always move towards Y*. To justify this behavior of the economy, let us consider what will happen if P < P*.

1. From the graph, we see that in this case YS < YD.

2. Since we are on the upward sloping part of the AS-curve, aggregate supply will not automatically increase. But since firms can sell everything they produce and since stocks are diminishing, they will raise prices.

3. When P increases, real wages W/P falls and L increases. With more labor, firms can increase production.

4. When P increases, the demand for money will increase. Interest rates will then increase and YD will fall (the LM-curve shifts upwards).

5. Overall, YS increases and YD falls when P increases. As long YS < YD, firms will continue to raise prices. Thus, prices will continue to increase until YS = YD and the economy is in equilibrium.

Determination of other variables

Once P and Y are determined, all other endogenous variables will be determined as well. The interest rate is determined by money market diagram and the components of GDP are either exogenous or they depend on R or Y. W is constant and since P is determined, so is the real wage. Then L and the unemployment rate is determined as well.

Note that although this diagram is looks exactly like the "standard supply and demand curves" for a single good from microeconomics, the derivation and interpretation is very different.

The equations of the AS-AD model

To summarize the AS-AD model, we can look at its equations. The IS-LM model was "solved" by simultaneously solving the equations

for Y and R. Since MS was exogenous, we had two equations and two unknown and the system of equation could be solved. The solution was illustrated by the IS-LM diagram.

In the AS-AD model, the situation is slightly more complicated because MD now depends on three variables: Y, R and P. We can no longer solve

for Y, R and P as we have three unknowns and only two equations. We need an additional equation in the AS-AD model. The third equation in the AS-AD model comes from the production function and the labor market. We showed that L depends on P and since YS depends on L, YS will depend on P. Equilibrium requires that their supply equals actual production, i.e., YS(P) = Y. The three equations of the AS-AD model are therefore

These are to be solved for Y, R and P. The solution is illustrated in the AS-AD diagram, where the first two equations are summarized in the AD curve YD(P) = Y.

Note how the three different versions of the Keynesian model we have studied so far are related to the number of variables/equations.

• In the cross model, we have only one variable (Y) and an equation: YD(Y) = Y.

• In the IS-LM model, we have two variables (Y and R) and two equations: YD( Y, R) = Y and MD(Y, R, P) = Ms.

• In the AS-AD model, we have three variables (Y, R, P) and three equations: YD(Y, R) = Y, MD(Y, R, P) = Ms YS(P) = Y.