ADAS model

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Aggregate supply/demand graph
The ADAS or aggregate demandaggregate supply model is a macroeconomic model that explains price
level and output through the relationship of aggregate demand and aggregate supply. It is based on the theory
of John Maynard Keynes presented in his work The General Theory of Employment, Interest, and Money. It is
one of the primary simplified representations in the modern field ofmacroeconomics, and is used by a broad
array of economists, from libertarian, Monetarist supporters of laissez-faire, such as Milton Friedman to Post-
Keynesian supporters of economic interventionism, such as Joan Robinson.
The conventional "aggregate supply and demand" model is, in actuality, a Keynesian visualization that has
come to be a widely accepted image of the theory. The Classical supply and demand model, which is largely
based on Say's law, or that supply creates its own demand, depicts the aggregate supply curve as being
vertical at all times (not just in the long-run)
Contents
[hide]
1 Modeling
2 Aggregate demand curve
3 Slope of AD curve
4 Effect of monetary expansion on the AD curve
5 Aggregate supply curve
o 5.1 Shifts in aggregate supply curves
6 Fiscal and monetary policy under Classical and Keynesian cases
7 Shifts of aggregate demand and aggregate supply
o 7.1 Shifts of aggregate demand
o 7.2 Shifts of aggregate supply
8 Monetarism
9 See also
10 References
o 10.1 Scholarly articles
11 External links
Modeling[edit]
The AD/AS model is used to illustrate the Keynesian model of the business cycle. Movements of the two
curves can be used to predict the effects that various exogenous events will have on two variables:
real GDP and the price level. Furthermore, the model can be incorporated as a component in any of a variety of
dynamic models (models of how variables like the price level and others evolve over time). The ADAS model
can be related to the Phillips curve model of wage or price inflation and unemployment.
Aggregate demand curve[edit]
Main article: Aggregate Demand
The AD curve is defined by the ISLM equilibrium income at different potential price levels. The Aggregate
demand curve AD, which is downward sloping, is derived from the IS/LM model.


ISLM curve


ADAS curve
It shows the combinations of the price level and level of the output at which the goods and assets markets are
simultaneously in equilibrium. The above figure showing IS and LM curves, where LM curve shifts downward to
the right to LM and thus shifting the new equilibrium to E where both goods and money market gets cleared.
Now, the new output level Y correspond to the lower price level P. Thus a reduction in price, which is shown in
the figure, leads to an increase in the equilibrium and spending.
The equation for the AD curve in general terms is:

where Y is real GDP, M is the nominal money supply, P is the price level, G is real government spending,
T is an exogenous component of real taxes levied, and Z
1
is a vector of other exogenous variables that
affect the location of the IS curve (exogenous influences on any component of spending) or the LM curve
(exogenous influences on money demand). The real money supply has a positive effect on aggregate
demand, as does real government spending (meaning that when the independent variable changes in one
direction, aggregate demand changes in the same direction); the exogenous component of taxes has a
negative effect on it.
Slope of AD curve[edit]
The slope of AD curve reflects the extent to which the real balances change the equilibrium level of
spending, taking both assets and goods markets into consideration. An increase in real balances will
lead to a larger increase in equilibrium income and spending, the smaller the interest
responsiveness of money demand and the higher the interest responsiveness of investment
demand. An increase in real balances leads to a larger level of income and spending, the larger the
value of multiplier and the smaller the income response of money demand.
This implies that: The AD curve is flatter, smaller is the interest responsiveness of the demand for
money and larger is the interest responsiveness of investment demand. Also, the AD curve is flatter, the
larger is the multiplier and the smaller the income responsiveness of the demand for money.
Effect of monetary expansion on the AD curve[edit]


Aggregate demand curve shifts rightward in case of a monetary expansion
An increase in the nominal money stock leads to a higher real money stock at each level of prices. In the
asset market, the decrease in interest rates induces the public to hold higher real balances. It stimulates
the aggregate demand and thereby increases the equilibrium level of income and spending.Thus, as we
can see from the diagram, the aggregate demand curve shifts rightward in case of a monetary expansion.
Aggregate supply curve[edit]
Main article: Aggregate supply
The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium. In
either case, it shows how much output is supplied by firms at various potential price levels. The aggregate
supply curve (AS curve) describes for each given price level, the quantity of output the firms plan to
supply.
The Keynesian aggregate supply curve shows that the AS curve is significantly horizontal implying that
the firm will supply whatever amount of goods is demanded at a particular price level during an economic
depression. The idea behind that is because there is unemployment, firms can readily obtain as much
labour as they want at that current wage and production can increase without any additional costs (e.g.
machines are idle which can simply be turned on). Firms' average costs of production therefore are
assumed not to change as their output level changes. This provides a rationale for Keynesians' support for
government intervention. The total output of an economy can decline without the price level declining; this
fact, in conjunction with the Keynesian belief of wages being inflexible downwards, clarifies the need for
government stimulus. Since wages cannot readily adjust low enough for aggregate supply to shift outward
and improve total output, the government must intervene to accomplish this result. However, the
Keynesian aggregate supply curve also contains a normally upward-sloping region where aggregate
supply responds accordingly to changes in price level. The upward slope is due to the law of diminishing
returns as firms increase output, which states that it will become marginally more expensive to accomplish
the same level of improvement in productive capacity as firms grow. It is also due to the scarcity of natural
resources, the rarity of which causes increased production to also become more expensive. The vertical
section of the Keynesian curve corresponds to the physical limit of the economy, where it is impossible to
increase output.
The classical aggregate supply curve comprises a short-run aggregate supply curve and a vertical long-
run aggregate supply curve. The short-run curve visualizes the total planned output of goods and services
in the economy at a particular price level. The "short-run" is defined as the period during which only final
good prices adjust and factor, or input, costs do not. The "long-run" is the period after which factor prices
are able to adjust accordingly. The short-run aggregate supply curve has an upward slope for the same
reasons the Keynesian AS curve has one: the law of diminishing returns and the scarcity of resources. The
long-run aggregate supply curve is vertical because factor prices will have adjusted. Factor prices increase
if producing at a point beyond full employment output, shifting the short-run aggregate supply inwards so
equilibrium occurs somewhere along full employment output. Monetarists have argued that demand-side
expansionary policies favoured by Keynesian economists are solely inflationary. As the aggregate demand
curve is shifted outward, the general price level increases. This increased price level causes households,
or the owners of the factors of production to demand higher prices for their goods and services. The
consequence of this is increased production costs for firms, causing short-run aggregate demand to shift
back inwards. The theoretical ultimate result is inflation.
[1]

Shifts in aggregate supply curves[edit]
The Keynesian model, in which there is no long-run aggregate supply curve and the classical model, in the
case of the short-run aggregate supply curve, are affected by the same determinants. Any event that
results in a change of production costs shifts the curves outwards or inwards if production costs are
decreased or increased, respectively. Some factors which affect short-run production costs include: taxes
and subsidies, price of labour (wages), and price of raw materials. These factors shift short-run
curves exclusively. Changes in the quantity and quality of labour and capital affect both long-run and short-
run supply curves. A greater quantity of labour or capital corresponds to a lower price for both. A greater
quality in labour or capital corresponds to a greater output per worker or machine.
The long-run aggregate supply curve of the classical model is affected by events that affect the potential
output of the economy. Factors revolve around changes in the quality and quantity of factors of production.
Fiscal and monetary policy under Classical and Keynesian cases[edit]
Keynesian Case: If there is a fiscal expansion i.e. there is an increase in the government spending or a cut
in the taxes, it will shift the AD curve rightwards. The shift would then imply an increase in the equilibrium
output and employment.
In the Classical case, the AS curve is vertical at the full employment level of output. Firms will supply the
equilibrium level of output whatever the price level may be.
Now, the fiscal expansion shifts the AD curve rightwards, thus leading to an increase in the demand for
goods, but the firms cannot increase the output as there is no labour force which can be obtained. As firms
try to hire more labour, they bid up wages and their costs of production and thus they charge higher prices
for the output. The increase in prices reduces the real money stock and leads to an increase in the interest
rates and reduction in spending.
The equation for the aggregate supply curve in general terms for the case of excess supply in the labor
market, called the short-run aggregate supply curve, is

where W is the nominal wage rate (exogenous due to stickiness in the short run), P
e
is the anticipated
(expected) price level, and Z
2
is a vector of exogenous variables that can affect the position of the
labor demand curve (the capital stock or the current state of technological knowledge). The real wage
has a negative effect on firms' employment of labor and hence on aggregate supply. The price level
relative to its expected level has a positive effect on aggregate supply because of firms' mistakes in
production plans due to mis-predictions of prices.
The long-run aggregate supply curve refers not to a time frame in which the capital stock is free to be
set optimally (as would be the terminology in the micro-economic theory of the firm), but rather to a
time frame in which wages are free to adjust in order to equilibrate the labor market and in which price
anticipations are accurate. In this case the nominal wage rate is endogenous and so does not appear
as an independent variable in the aggregate supply equation. The long-run aggregate supply equation
is simply

and is vertical at the full-employment level of output. In this long-run case, Z
2
also includes factors
affecting the position of the labor supply curve (such as population), since in labor market
equilibrium the location of labor supply affects the labor market outcome.
Shifts of aggregate demand and aggregate supply[edit]
The following summarizes the exogenous events that could shift the aggregate supply or
aggregate demand curve to the right. Exogenous events happening in the opposite direction
would shift the relevant curve in the opposite direction.
Shifts of aggregate demand[edit]
The following exogenous events would shift the aggregate demand curve to the right. As a result,
the price level would go up. In addition if the time frame of analysis is the short run, so the
aggregate supply curve is upward sloping rather than vertical, real output would go up; but in the
long run with aggregate supply vertical at full employment, real output would remain unchanged.
Aggregate demand shifts emanating from the IS curve:
An exogenous increase in consumer spending
An exogenous increase in investment spending on physical capital
An exogenous increase in intended inventory investment
An exogenous increase in government spending on goods and services
An exogenous increase in transfer payments from the government to the people
An exogenous decrease in taxes levied
An exogenous increase in purchases of the country's exports by people in other countries
An exogenous decrease in imports from other countries
Aggregate demand shifts emanating from the LM curve:
An exogenous increase in the nominal money supply
An exogenous decrease in the demand for money supply i.e. liquidity preference
Shifts of aggregate supply[edit]
The following exogenous events would shift the short-run aggregate supply curve to the right. As
a result, the price level would drop and real GDP would increase.
An exogenous decrease in the wage rate
An increase in the physical capital stock
Technological progress improvements in our knowledge of how to transform capital and
labor into output
The following events would shift the long-run aggregate supply curve to the right:
An increase in population
An increase in the physical capital stock
Technological progress
Monetarism[edit]
The modern quantity theory states that the price level is directly affected by the quantity of
money. Friedman is the recognized intellectual leader of an influential group of economists, called
Monetarists, who emphasize the role of money and monetary policy in affecting the behaviour of
output and prices. Modern quantity theory also disagrees with the strict quantity theory in not
believing that the supply curve is vertical in the short run. Thus, Friedman and other monetarists
made an important distinction between the short run and long run effects of changes in money.
They said that in the long run money is more or less neutral. Changes in real money stock have
no real effects and only change prices. But in the short run, they argue that the monetary policy
and changes in the money stock can have important real effects.