SAS-LAS-AD model of the neo-classical synthesis

AS-AD in the Keynesian and the classical model

First, a brief review of the AS-AD model according to the classical and the Keynesian model when W is constant and exogenous.

Fig. 15.5: The two AS-AD models.

According to the classical model, aggregate supply is independent of the price level and equal to potential GDP. Potential GDP is the amount produced when U = UN and the AS curve becomes a horizontal line through Ypor

The AD curve in the classical model consists of combinations of Y and P where the quantity theory M-V = P-Y is satisfied. Aggregate demand is equal to the aggregate supply according to Say’s Law. In the classical model, one starts from Y and finds P from the AD curve. The only function of the AD curve in the classical model is to determine the price level.

The AD curve slopes downwards in the Keynesian model as it does in the classical model but interpretation and the reason are quite different. In the Keynesian model, you start with P and you find YD from the AD curve. Here, the AD curve slopes downwards because when P falls, R decreases, I increases and YD increases (see section X). Another difference is that the AD curve may be affected by fiscal and monetary policy in the Keynesian model but not in the classical model.

In the Keynesian model, the AS curve is horizontal for low value of Y. In this region, the AS curve determines P while the AD curve determines GDP. Aggregate supply will be equal to aggregate demanded by the reverse Say’s Law. For higher values of Y you need higher prices to stimulate aggregate and the AS curve will slope upwards. In this region, the AS and the AD curves simultaneously determine P and Y.

SAS, LAS, and AD

In the neo-classical synthesis, the Keynesian model is correct in the short run while (a slightly modified version of) the classical model applies in the long run. We therefore need to reconcile the AS-AD analysis of these models. In synthesis, the following concepts are introduced:

• Long-run aggregate supply (LAS): The classical AS curve (L for Long run)

• Short-run aggregate supply (SAS): The Keynesian AS curve (S for Short run)

In synthesis, it is the Keynesian AD curve that must be used. We can combine SAS, LAS, and AD in the same graph.

Fig. 15.6: SAS, LAS, and AD.

We begin by drawing them in such a way that both models agree in the determination of Y, Y = YpoT. In the synthesis, this corresponds to long run equilibrium - there is no tendency for Y to increase or decrease.

Note that the price level is determined in according to the Keynesian model both in the short and the long run (as we use the Keynesian AD curve). There is no reason however, to believe that this price level is consistent with the quantity theory. In other words, the classical AD curve (not shown) may intersect LAS at a completely different P. The quantity theory in levels need not hold in the neoclassical synthesis neither in the short run nor in the long run. However, the quantity theory in rates (n = nM) must hold in the long run. Therefore, it is not entirely correct to claim neo-classical synthesis reduces to the classical model in the long.

The dynamics from the short to the long run

We will now describe the dynamics from short to the long run in the LAS-SAS-AD model. To avoid having AS and AD curves "gliding", we will assume that nM = 0. The case nM ^ 0 is not much harder to analyze.

We begin by analyzing an increase in MS (nM is still zero - except for the brief when MS increases, which we assume is very short). We start in the long-run equilibrium as in Figure 15.6. Initially n = nw = if = 0.

Fig. 15.7: Dynamics in the neo-classical synthesis.

1. We are in the initial point A.

2. When MS increases, the AD curve moves outwards from AD1 to AD2.

3. We move from point A to point B. Y increases and P increases.

4. As Y increases, U falls and we moving to point B on the SPK.

5. At point B on the SPK, wages increases.

6. When wages increase, the SAS curve will shift upwards.

7. When the SAS curve shifts upwards, Y will fall and U will again increase. We move back along the SPK.

8. The SAS curve must continue to shift upwards as long as Y > YpoT. It will shift from SAS1 to SAS2 and we move to point C. We are back on the LAS and we are back on the LPK.

Whenever you use the neo-classical synthesis for your analysis, you should begin as if you where using the Keynesian model (with exogenous wages). This will give you the short-run outcome. To obtain the long-run results, remove the assumption of exogenous wages. Let wages adjust so that you will return to LAS and LPC.