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AS AD Model, Maccroeconomics Models, Assignment Help, Homework Help
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ASADmodel Introduction
The problem with the ISLM model The starting point of the ASAD model is an assumption in the ISLM 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
_{oPT}
), they would produce more than the aggregate demand. In the ISLM, Y
_{OPT}
> Y
_{D}
must hold.
To realize why this is a problem in the ISLM model, we gradually increase the aggregate demand by increasing G.
Illustrating the problem in the ISLM model
1. Let us begin with a given real wage W/P, an IS curve (IS
_{0}
) and an LM curve. In equilibrium, we will have Y = Y
_{0}
and L = L
_{0}
.
2. Now increase G so that IS curve shifts outwards from IS
_{0}
to IS
_{1}
In the first step, we increase G just enough so that Y = Y
_{OPT}
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 L
_{OPT}
which is precisely the profitmaximizing 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 ISLM model.
4. Now imagine that we increase G even more so that the IS curve shifts to IS2 such that so that Y = Y
_{2}
> Y
_{on}
. Now the ISLM model is in trouble.
5. According to the production function, to produce Y = Y
_{2}
we need L = L
_{2}
. But firms will only hire LOFT if the real wage is constant (which is assumed in the ISLM model). LOFT is the profit maximizing quantity  to produce more would reduce profits.
6. As firms will not hire more than L
_{OPT}
if real wages are constant, GDP cannot be larger than of Y
_{OPT}
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 IScurve. The same problem appears when we change Ms and shift the LMcurve. If we shift the LMcurve to the right by an amount such that Y> Y
_{OPT}
, the ISLM model cannot be used.
The ISLM model is not "wrong", but it is applicable only as long as Y > Y
_{OPT}
. Generally, the ISLM 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 ASAD model solves the problem
The purpose of the ASAD model is to extend the ISLM model so that we can analyze situations where Y > Y
_{OPT}
. To accomplish this, we must make P endogenous in the ASAD model. When P is endogenous and allowed to vary, real wage WI P may vary even if the nominal wage W is fixed. The ASAD 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.
When P is allowed to increase, real wage WI 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 ASAD model Summary
The most important change we make going from the ISLM model to the ASAD model is to allow P to be endogenous. Since P was constant in the ISLM model, we must "redo" the ISLM 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, Y
_{D}
(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 ASAD model. In the ASAD 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 ISLM model, aggregate supply was simply equal to aggregate demand but this is no longer the case in the ASAD model.
• Since real wages are no longer constant, we must make a more detailed analysis of the labor market.
The ASAD model and inflation
Even though the ASAD 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.
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