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Q. Explain function of AS-AD model?
The function of AS-AD model is to extend IS-LM model so that we can analyze situations where Y > YOPT. To achieve this, we should make P endogenous in the AS-AD model. When P is endogenous as well as allowed to vary, real wage W/P may vary even if nominal wage W is fixed. AS-AD model, hence, maintains 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 that he quite vigorously argue that 'wages tend to be sticky in terms of money'whereas real wages won't be as stable.
When P is allowed to increase, real wage W/P may fall and with a lower real wage, labor demand would increase and so will GDP (as long as there is adequate demand). By making P endogenous, we can allow for Y to be greater than YOPT.
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