CLASSICAL MACROECONOMICS

AND KEYNESIAN GENERAL

EQUILIBRIUM OF THE AS-AD
MODEL
ECN 341 Lecture 7
Onyebuchi Iwegbu
INTRODUCTION
• Understanding of the various types of market.
• Recall the General Determination of the IS-LM model.
• Demand-Side factors and the supply side factors.
INTRODUCTION (CONTD.)
• Unrealistic assumptions (classicalist)
• the role of the supply-side factors, viz., production function, labour market,
wages and employment, ignoring the demand side factors and relies on the
Say’s law.
• Unrealistic assumptions (Keynesian)
• excess production capacity
• production function with constant returns
• constant wages
• neutrality of government’s fiscal and monetary actions.
INTRODUCTION (CONTD.)
• Derivation of the Aggregate demand function.
• Effect of policy changes
• Fiscal and monetary policy
In practice, we have implicitly assumed that is the demand side of the economy
(demand for consumption, investments and public expenditure) that determines Önal
output. Therefore, in the IS-LM model there is no role for the supply side of the
economy in determining Önal output. To overcome this issue, another macro model,
called the AD-AS model, has been developed, where the equilibrium output is now
determined by the intersection of aggregate demand (AD) and aggregate supply (AS).
Moreover the IS-LM model is for short-run analysis, where indeed demand plays an
important role in determining output. However, the IS-LM model is not really suitable
to understand what may happens in the economy in the long-run (exactly because
there is no supply and we know that in the long run output is determined by the
production activity of firms using inputs such as labour and capital). The AD – AS model
overcomes this problem.
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
• The nature of the classical and Keynesian aggregate supply curves has been at the
centre of controversy between the Keynesians and classical economists.
• Classicalists
• According to classical theory of output determination, given the production
function, the maximum level of output is determined at the level of full
employment. The classical economists postulated that an economy is always at full
employment. Since the economy is always at full employment, the maximum level
of output is always fixed. This implies that aggregate supply (AS) is always constant,
whatever the level of price. Thus, the classical AS is given by a straight vertical line.
• According to classical economists output, when prices are fully flexible, is
determined by factor supplies and technology: Y = F(K; L), where Y denotes the
Natural Level of output (i.e. the full employment level of output).

• Why does the output not increase if price level increases? – The internal
adjustment mechanism.
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
Keynesians
• The classical economists assumed an idealised, perfectly competitive labour market
and highly flexible wages. In the classical system, therefore, due to flexibility of
wages, the labour market adjusts instantly to the full employment equilibrium,
whenever there is any discrepancy between labour demand and supply.
• Keynes believed that wages are rigid, especially in their downward adjustment; this
is due to:
• One, he believed that labour market is, by and large, imperfect because of labour union
influence—not perfectly competitive Contractual wages do not vary during the period of
contract following the change in labour demand and supply.
• Two, workers are interested in their absolute as well as relative wages. In wage bargaining,
both unions and employers recognise the need for relative parity in wage rate structure.
Therefore, wages do not fall even when there is a sudden fall in labour demand or a sudden
increase in labour supply.
• Three, even in the labour market segments where there are no unions, there is an
understanding between the labour and employers that wages once fixed will not be cut down
if there is sudden decline in the demand for labour.
• Keynes believed that a downward movement in wages is resisted by the workers
and an upward movement is resisted by the employers.
DERIVATION OF THE AGGREGATE SUPPLY CURVE
(CONTD.) Any change in the demand (and so any economic
policy, fiscal and monetary) will affect the general
price level but not the amount produced which is
determined only by the supply side of the
economy. If money supply increases, AD shifts up
(it increases), output does not change while prices
increase. This is consistent with the quantity theory
of money, but here this is true also in the short run
and not only in the long run. As I said now
economists believe that the classical case is not the
right one to describe the short-run but it is a good
representation of the economy in the long run.
Therefore, for a classical economist: Output is
determined by:
• The supply side: amounts of capital, labour and
technology (Y=AKL)
• Changes in demand for goods and services only
affects prices and not output
• Economic policies (monetary and fiscal) have no
effect on output
• Assumes complete price áexibility
• The classical theory applies to the long-run
DERIVATION OF THE AGGREGATE SUPPLY CURVE
(CONTD.) The aggregate supply is horizontal in the short run
since prices are fixed. However as we reach the full
employment, according to Keynes, any further increase
in demand will be reflected in an increase in the prices
only.
Notice: prices here are fixed but they can increase if we
go beyond the full employment level of output.
However prices cannot decrease below P*. Prices are
sticky downwards.
Notice also that in the short-run we may be well below
the full employment as Keynes argued in the General
Theory. A way to move towards the full employment is
to use policies (like increasing government
expenditure) to shift the AD towards the natural level
of output.
For a Keynesian economists we have:
• Prices are fixed (or at least sticky) in the short-run
• Output depends on aggregate demand in the short-
run and on the supply side once we reach full-
employment
• Economic policies (monetary and fiscal) have a short
run effect on the level of output;
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
The AD-AS Curve and Price Stickiness
i. The Classical and the Keynesian case are two extreme versions of the AD-
AS model. They are extreme on the assumption about the aggregate price
level in the short run. Classical case P is always fully flexible (and so also in
the short-run) while in the Keynesian case is fixed in the short-run. We
make an assumption in between these two extreme cases: we assume that
the aggregate price level P is sticky. This means that the aggregate price
level can change in the short run but it does not fully adjust after a change
in the economy. Why? Two firms and their reactions to price changes
 The Short-Run Aggregate Supply (SRAS) and
the Long-Run Aggregate Supply (LRAS)
i. The LRAS is consistent with the Classicalists and so vertical at the natural
level of output.
ii. In the SRAS, there is a positive relationship between the aggregate price
level and the level of output. 3 models explains this:
i. Sticky wages model
ii. Sticky prices model
iii. The Lucas’ Imperfect Information Model
 The Short-Run Aggregate Supply (SRAS) and
the Long-Run Aggregate Supply (LRAS)
i. Sticky wages model
i. This model links the labour market and the aggregate supply.
ii. Recall that Y=F(K,L) capital is fixed and L is the level of employment.
iii. Thus, if L increases, Y increases. Let us consider how L is determined.
iv. The sticky wages assumes that in the short run, nominal wages are sticky. Why?
v. In particular, even if the bargaining is over the nominal wage, what really matters for the
firm and the worker is the REAL wage. The real wage gives you the amount of goods you can
buy with your nominal wage (W/P).
vi. We assume that the wage target that determines the bargained wage is the real wage that
will make the labour market in equilibrium (Labour demand = Labour supply). Therefore,
firms and workers bargain the following nominal wage: W=a.Pe

vii. The basic idea is: if the nominal wage is sticky, then increases in the price level cause the
real wage to fall, which causes firms to hire more workers and produce more output.
 The Short-Run Aggregate Supply (SRAS) and
the Long-Run Aggregate Supply (LRAS)
i. Sticky wages model
The Short-Run Aggregate Supply (SRAS) and the Long-Run Aggregate
Supply (LRAS)
Sticky prices model
In this model we assume that there are some firms in the economy that can adjust their prices
quickly while some other firms set prices in advance and for a given period of time. Each firm
produces a single good. As we can see a basic assumption here is that firms are price-setters. This
implies that we are assuming some sort of inefficiency in the market since we are not in a
competitive market framework. In particular, we have in mind a market structure that is given by
monopolistic competition = many firms producing differentiated goods. There may be several
reasons why some firms cannot adjust their prices quickly, for example:
• long-term contracts between firms and customers;
• menu costs;
• firms not wishing to annoy customers with frequent price changes;
The desired price level that a firm would like to set depends on two main variables:
(a) The overall price level P. A higher aggregate price level implies that firm’s costs are higher. So
the higher the overall price level and higher is the price a firm would like to set for its product.
(Differently from a competitive market here firms produce differentiated product. If a firm charges
a higher price than its rivals it does not lose all its demand);
(b) The level aggregate output Y . Higher is aggregate output and higher is the demand faced by a
given firm. Higher is the demand and higher will be the price that particular firm would like to set.
The Short-Run Aggregate Supply (SRAS) and the Long-Run Aggregate
Supply (LRAS)
The Lucas Imperfect Information model
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
The AD-AS Model
Using the concepts explained so far, the AD-AS model consists of 3 elements:
1. An aggregate demand (AD) that is downward sloping;
2. A short run aggregate supply (SRAS) that is upward sloping;
3. A long run aggregate supply (LRAS) that is vertical at the natural level of
output; Graphically the AD-AS model looks like this:
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
The AD-AS Model
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
The AD-AS Model
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
Shocks in the AD-AS Model
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
Shocks in the AD-AS Model
 DERIVATION OF THE AGGREGATE SUPPLY CURVE
Prices and Inflation in AD-AS
 DERIVATION OF THE AGGREGATE SUPPLY CURVE

Increases in price level, money wage given, increases the MP x P and leads to rise in employment which results in
rise in output.
 POLICY OPTIONS
Employment Effect of Fiscal Policy
 POLICY OPTIONS
Employment Effect of Monetary Policy
 POLICY OPTIONS
Supply Shocks and Policy Dilemma