IS-LM and AS-AD Model

IS-LM and AS-AD Model

What are the AD and AS curves?

 The aggregate demand curve AD, asserts the existence of a stable meaningful inverse comparative static relation between the average price level, AP, of final goods and services and the total or aggregate quantity demanded, AQd, of final goods and services per unit of time.  The aggregate supply curve, AS, makes the symmetrical assertion that the flow of total quantity supplied, AQs, is directly (rather than inversely) related to AP.

Why is the AQd inversely related to AP?  Given the money supply, M, and given the velocity, V, at which money moves from hand to hand in exchange for final output, then the equation of exchange tells us that the product of AP and AQd is a constant or that AQd is inversely related to AP.  In other words, a larger demand for a quantity flow of final sales, AQd, can be transacted with the current stock of money only at lower average prices bid by the demanders, APd, when the velocity of money is stable.  Of course, when AQd is relatively large and money is relatively scarce, then loans will be relatively hard to get, the interest rate will be relatively high and transactors will economize on "barren" cash by using it more intensively and moving faster, i.e., by increasing the velocity of cash, which partly migrates the initial scarcity.

 

B) Of what use are the AD and AS curves?

Inflation and unemployment always top the list of citizens' concerns in public opinion polls on the macro economy.  The AD and AS curves are useful for analyzing the effect on equilibrium AP and AQ either of a shift in AD and the implied movement along AD.  Thus, AD and AS help us to understand the two main macro economic issues of inflation, which is the percentage  rate of increase of issues of inflation, which is the percentage rate of increase of AP over time, and unemployment, which is related through Okun's law to the percent by which AQ falls short of its potential.

 

C)  How are the AD and AS curves different from their microeconomic counterparts DD and SS?

Total income of the economic system is taken as a fixed parameter in the microeconomic "partial equilibrium" analysis of a particular market, so individual price can be determined (which explains why micro economics used to be called the theory of price).  But when we look at the whole economic system, total income is no given, but is precisely the thing whose equilibrium value we want to discover.  So aggregate income (which cannot differ, for the system as a whole, from total real output, AQe explains why whole-system or "macro" economics used to be called the theory of income determination).

AD differs from DD because the macro view sees the entire circular flow which feeds back any initial change of spending to create additional re-spending of income.  This multiplies the total effect over time of any initial change of spending by capturing the secondary, tertiary and ...