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Cambridge Journal of Economics 2007, 31, 413–422

doi:10.1093/cje/bel027
Advance Access publication 8 November, 2006

The nature of the ADAS model based on


the ISLM model
B. Bhaskara Rao*

The aggregate demand and supply model (ADAS) is interpreted as a synthesis of


the Keynesian and neoclassical models. It uses the ISLM model, without explaining
its nature, to derive aggregate demand (AD). It is combined with an aggregate
supply (AS) curve to explain price-inflation and output dynamics. This paper
argues that neither the AD nor the AS curve is conceptually the same as its
microeconomic counterpart and that ADAS is not a synthesis. In fact, ADAS
implies that discretionary policy is necessary and that price changes do not perform
their traditional negative feedback function.

Key words: Keynesian and neoclassical models, Aggregate demand and supply,
Monetary policy rule, Price adjustments, Stabilization policy
JEL classifications: E0, E41, E52

1. Introduction
Current macroeconomic textbooks use different approaches to develop an aggregate
demand and supply (ADAS) model in which there is a downward-sloping aggregate
demand curve (AD) and an upward-sloping aggregate supply curve (AS) in the price and
+
output space (P, Y ) or inflation and output space ( P ; Y ). It is believed that such familiar-
looking AD and AS curves help students to grasp easily the working of the macroeconomic
system because ADAS resembles the familiar demand and supply model of a single goods
market in microeconomics. However, the textbook ADAS models fail to achieve their
ultimate objective. Students are left more confused about the working of the economic
system with ADAS and an early opportunity to teach the students to look at the economy
from the perspective of interdependent markets is also lost. Consequently, there is
perpetual confusion over whether ADAS is a single goods market model or a model of
interrelated aggregate markets of goods, labour, money and bonds.1 Furthermore, since
different approaches are used in the textbooks to derive the ADAS model, a student using

Manuscript received 9 September 2005; final version received 12 May 2006.


Address for correspondence: University of the South Pacific, Suva, Fiji; email: raob@connect.com.fj
* University of the South Pacific. I thank two anonymous referees of this journal for several valuable
suggestions. I am also grateful to Professors John Nevile, John Lodewijks and Dr Mehdi Monadjami of the
University of New South Wales, Professor Sally Stewart of the Graduate School of Business, the University of
the South Pacific, my colleague Rup Singh and the participants at the Australian Conference of Economists
2004, Sydney, for useful suggestions. However, responsibility for errors remains with me.
1
In the past a similar confusion caused Rowan (1975) to develop, from ISLM, a kinked aggregate demand
function for the goods market. Rao (1986) argued that the Rowan demand curve does not exist.
Ó The Author 2006. Published by Oxford University Press on behalf of the Cambridge Political Economy Society.
All rights reserved.
414 B. Bhaskara Rao
a first year book, based on a particular approach, later finds that ADAS in the second and
third years is different.1
This paper takes the view that the current textbook emphasis on the similarities between
price–output determination in a single goods market of microeconomics and the aggreate
goods market in macroeconomics is inappropriate. The sooner this practice is given up the
better would be our insight into the working of real world economic systems. This paper is
organised as follows. In Section 2, the nature of the ISLM model is explained. In Section 3,
a recent textbook variant of the ADAS model, based on Romer (2000) and Taylor and
Moosa (2002), is examined. Section 4 examines the derivation of aggregate demand, based
on some earlier textbook versions of ADAS. Finally, conclusions are presented in Section 5.

2. Nature of the ISLM model


At the outset, it is important to emphasise that there are significant differences between the
textbook Keynesian models based on Hicks’s ISLM and what is acceptable as Keynesian to
many post-Keynesian economists. While ISLM, like the Walrasian model, is concerned with
an exchange economy, the Keynesian model of The General Theory, and the subsequent post-
Keynesian models, use a monetary production economy in which time and uncertainty play
important roles. Therefore, it is perhaps more appropriate to call the textbook Keynesian
models Hicksian rather than Keynesian, or ISLM with some Keynesian features.2
This practice of treating ISLM as Keynesian may be due to two important Keynesian
results of ISLM. First, unemployment is shown to be due to the deficiency of aggregate
demand and not to rigid wages; and, second, the rate of interest is determined in the money
market and not by the real forces behind saving and investment decisions. Although these
results of ISLM are based on theoretical insights, there is considerable evidence to show
that the wage elasticity of demand for labour is very low and the real rate of interest does
not show large fluctuations, although the expectations of investors are volatile. Therefore,
ISLM, at best, is observationally equivalent to what is considered to be a Keynesian model
by the post-Keynesians. However, it is hard to change the current widely used textbook
practice of treating ISLM as a Keynesian model, and our use of the term ‘Keynesian’ for
ISLM and ADAS should be seen from this perspective.
In virtually all types of textbook quasi-Keynesian models (henceforth Keynesian with
the aforesaid caveats), goods prices are set by firms and not determined, as in
microeconomics models, by the market forces of demand and supply. Furthermore,
output is determined by demand and not even by the Min. condition of the disequilibrium
models.3 These Keynesian ideas are already incorporated into ISLM and therefore ADAS
models in which ISLM is used to derive AD are already Keynesian in nature.
1
For example, a first year student may use McTaggart et al. (2003) or Taylor and Moosa (2002) and, later
in the second year, for example, Dornbusch et al. (1999). In McTaggart et al. and in Dornbusch et al.
although AD is derived from ISLM, derivation of AS is different. Unlike in these two approaches, Taylor and
Moosa derive a downward sloping AD curve based on Romer (2000). A number of other textbooks use one or
another of these three approaches.
2
A referee has pointed out that it is impossible to integrate (or develop a close association with) Keynesian
and ISLM and/or ADAS approaches owing to fundamental theoretical differences regarding the nature of
money, time and uncertainty. While we agree with this view, it is difficult to address these inresolvable
theoretical issues in a paper limited to an examination of the confusions in the current textbook models.
3
There is considerable evidence, based on the non-nested hypothesis tests and the standard likelihood
ratio tests, to support these assumptions; see Pesaran (1982, 1988) and Rao (1992, 1993A) for evidence
based on the non-nested hypothesis tests and Rao and Srivastava (1991) and Rao (1993B, 1994) for evidence
with likelihood methods for the US and UK economies. In Rao (1993B) it is found that more than 85% of the
US GNP transactions take place in the sluggish price markets.
The ADAS model 415
It is important to understand Hicks’s later clarifications of the nature of his ISLM in
Hicks (1983)—a much neglected contribution compared with the famous Hicks (1937). In
Hicks (1983), he was more sceptical about claiming that ISLM is a true representation of
Keynes and admits that ISLM is actually a product of his Walrasian nature, and it is his way
of representing the Keynesian three-way exchange in the goods, money and bond markets
on a two-dimensional diagram. He goes further to clarify the differences between the all
flex-price Walrasian general equilibrium system (GE) and his ISLM. Therefore, according
to Hicks, the ISLM model should be seen as a simple Walrasian GE model with only three
markets and two relative prices, i.e., the price of goods and the price of bonds which is the
reciprocal of the rate of interest. Because of Walras law, if two markets are in equilibrium
the third market must be also in equilibrium. Therefore, the three-way exchange can be
understood by analysing any two markets. Hicks ignored the bond market. His ISLM,
therefore, analyses the conditions under which the goods and money markets can be in
equilibrium.
There is, however, an important difference between ISLM and Walrasian GE. While in
the Walrasian model all markets are flex-price, or P markets in Hicks’ terminology, in
ISLM the bond and money markets are P markets and the goods market is a fix-price, or
a Q market. In other words, equilibrium in the goods market is achieved through quantity
instead of price adjustments. This adjustment process can be easily explained with the 45°
line and the aggregate demand function. It differs from the standard price adjustment
model in some important respects. First, firms actually produce output in anticipation of
demand. Second, if actual demand differs from the anticipated demand, firms adjust their
production plans (not prices) with a lag. Third, equilibrium through quantity adjustments
is not instantaneous. This seems to be a more realistic description of how the goods market
in a production economy functions than the Walrasian market, where it is not known who
adjusts prices. It is in this sense that ISLM is novel and incorporates certain key Keynesian
features.1
Once the fix-price assumption is introduced into the Walrasian system, its nature and
conclusions change. In contrast to the Walrasian system where all the demand and supply
functions depend on relative prices and initial endowments, in the fix-price systems these
relationships depend on the relative prices and initial endowments in the P markets and,
instead of relative prices, on the quantities actually transacted in the Q markets. It is for this
reason that the Keynesian consumption function depends on current income, instead of
the inter-temporal relative price of consumption, i.e., the real rate of interest. Furthermore,
while in GE adjustment to equilibrium is through price changes, in ISLM, as stated earlier,
such adjustment is through quantity adjustments. Unlike in GE, equilibrium in ISLM is
affected by monetary and fiscal policies. The system may remain in underemployment
equilibrium for a long period if there is no policy intervention. It is for this reasons that
ISLM can be said to have successfully formalised Keynes’s underemployment equilibrium.
1
Critiques of ISLM who point out that it lacks micro foundations ignore totally Hicks (1983). Those
critical of the fix-price assumptions, including Solow (see below), may note that there is no micro foundation
for the market clearing assumption through price adjustments in the Walrasian model; see Arrow (1981, pp.
141–2) and Benassy (1986A, p. 3). While admitting that disequilibrium models deserve further attention,
Solow (2000, p. 152) says I hold the minority view that the fixed-price models of Malinvaud (1977), Benassy
(1986b) and others were never given a fair trial by American macroeconomists. No doubt there were some
good reasons for this negative verdict; for example, the fixed-price models lacked any serious story about how
prices eventually move . These criticisms of the American macroeconomists are hard to understand,
because partial price adjustments can be incorporated into the fix-price theoretical disequilibrium models.
That is, transactors move towards an equilibrium price by a trial and error process. Many empirical
disequilibrium models use partial price adjustment equations.
416 B. Bhaskara Rao
Finally, what is the nature of the labour market that has been ignored in ISLM? It can be
either a P or a Q market, but Hicks says that it is a Q market although admitting that
Keynes might have thought that it is a P market; see Hicks (1983, p. 54).1
Therefore, combining an AD function derived from ISLM with an AS function derived
from a Walrasian-style labour market to illustrate, among other things, the differences
between the Keynesian and the new and neoclassical (henceforth neoclassical) models is
methodologically unsound. It may also be noted that when firms are demand constrained
in the goods market, there cannot be a supply curve. Thus neither AD nor AS is
conceptually the same as its counterpart in the competitive microeconomic model.
Furthermore, given the underlying Keynesian features of the ISLM model, it is even more
amazing that many US macroeconomists, claiming to be Keynesians, uncritically accept
ADAS to show that the economy is capable of attaining full employment equilibrium,
sooner or later, through price adjustments. Therefore, any discretionary policy can be seen
only as a catalyst to speed up this process of price adjustment.2
In spite of these limitations, if AD and AS are given a more accurate interpretation, with
some simplifying assumptions for expository convenience, they can be used to analyse
aggregate output and price level or the rate of inflation and establish a key Keynesian result,
that the economy may remain in underemployment equilibrium for prolonged periods.
However, ADAS based on ISLM is not an appropriate framework for analysing the market
oriented neoclassical models. Which one of these rival models is more appropriate for
explaining the observed facts is an age old question. But existing empirical evidence favour
the models with Keynesian features.

3. ADAS models
Macroeconomics textbooks of an earlier generation, e.g., Ackley (1961), Crouch (1972)
and Felderer and Homburg (1987) have described and illustrated how the flex-price
classical macro system works. Early diagrammatic versions of the ISLM model have also
used a similar approach. In the Classics versus Keynes controversy and later in the
Monetarist controversy, these graphical models have been used successfully. However,
following the uncritical acceptance of ISLM by the Monetarists, and the popularity of the
Phillips curve and its expectations augmented versions, it was thought necessary to extend
ISLM to explain the high rates of inflation of the early 1970s. Since ISLM was perceived to be
a model of AD, an AS curve was developed to determine output and price level (or inflation)
within a unified framework analogous to the partial equilibrium demand–supply model in
1
A second referee has pointed out that Hicks (1937) was originally formulated in terms of the ‘wage-unit’.
However, Hicks (1983) does not use this concept. Keynes seems to have used wage units partly to overcome
the aggregation problems in measuring aggregate output at a time when there was no macroeconomics.
According to Bradford and Harcourt (1997), the use of ‘wage-unit’ in The General Theory unnecessarily
complicated Keynes’s exposition. It is also hard to understand why Hicks (1983) did not make use of the
distinction between the notional and effective demands of Clower and Leijonhufvud to argue that whether
the labour market is a P or a Q market is irrelevant when the goods market is a Q market. Even if the labour
market is modelled as a P market, demand constrained firms do not increase employment even if workers are
willing to accept lower real wages.
2
These limitations in the textbook derivations were first noted by Rao (1991) and later by Nevile and Rao
(1996). Colander (1995) made similar criticisms, unaware of these earlier contributions, but acknowledged
their existence in Colander (1996). The point made by these critiques is that the assumptions in the textbook
ADAS are inconsistent because the derivation of AD comes from a Keynesian fix-price ISLM model, and its
implication for the derivation of the effective demand for labour and labour market adjustments are ignored
in the derivation of AS. A similar confusion was also present in the Keynes versus the Monetarists debate.
Perhaps Friedman uncritically admitted that We are all Keynesians now when he accepted ISLM as a suitable
framework for the monetarist and Keynesian approaches.
The ADAS model 417
microeconomics. In this process, the interrelationships between the markets at the macro
level are ignored. This neglect to some inconsistencies between the assumptions underlying
the derivation of AS and AD. To understand these inconsistencies, it is important to note
that ISLM is a three-market model, and the consumption function in ISLM is Keynesian in
nature and derived from a fix-price goods market. Therefore, ADAS models that use ISLM
to derive AD and then ignore its implications for the derivation of AS and modifications to
the labour market, as noted by Rao (1991), Nevile and Rao (1996), Nevile (1997) and
Colander (1995), are based on contradictory assumptions.
Textbooks have used three approaches to derive AS. First, AS is derived by inverting
the Phillips curve in Dornbusch et al. (1999) and Taylor and Moosa (2002). The inverted
Phillips curve is interpreted as a reduced form mark-up price-setting equation based on
a disequilibrium labour market. Sometimes this inverted Phillips curve is also called an
aggregate supply curve. However, there are conceptual problems here. While the Phillips
curve is a price adjustment equation, the supply curve is a quantity adjustment equation.
Therefore, an inverted Phillips curve cannot be a supply curve. Second, AS is also derived
in several neoclassical textbooks using a Walrasian flex-price labour market. However, both
approaches uncritically accept ISLM to derive AD. Therefore, they give the impression
that AD and AS are the demand and supply relationships of a single aggregate goods
market. The main weakness of these approaches is that movements towards equilibrium
are explained only in terms of price adjustments. The role of spillover effects from the fix-
price goods market in ISLM on the demand for labour and the fact that flexible money
wages cannot restore full employment equilibrium have been ignored. A third and more
recent derivation of ADAS is by Taylor and Moosa (2002). It is based on Romer (2000)
and differs somewhat from the earlier textbook derivations. We shall refer to this approach
as RTM. In this version, AD is also derived from ISLM but with some modifications. We
shall examine this model in some detail, because the weaknesses in the other two versions
of ADAS have been already explained by Rao, Nevile and Colander. The main criticisms of
these authors is that ISLM is useful for analysing models in which some markets are fix-
price and others are flex-price. Therefore, an ADAS model in which ISLM is retained gives
the wrong impression that adjustment to equilibrium is through price flexibility. In fact, an
economy in which quantity adjustments take place, as in ISLM, may remain in
underemployment equilibrium for prolonged periods even if prices are flexible. To keep
the exposition simple, we shall use a standard textbook ISLM closed economy model.

Y ¼CþI þG ð1Þ

C ¼ c0 þ c1 ðY  T Þ ð2Þ

+
I ¼ i0  i1 ðr  P Þ ð3Þ

G¼G ð4Þ
 
M
¼ l0 þ l1 Y  l2 r ð5Þ
P
where Y is output, C is real consumption, I is real investment, r is nominal rate of interest,
+
P is rate of inflation, T is taxes, G is autonomous government expenditure, P is price level
and M is nominal money supply.
418 B. Bhaskara Rao
Price expectations are ignored for convenience and replaced with the actual rate of
inflation. Adding expectations does not change the nature of the model. This simplification
is useful for analyzing output and inflation instead of output and the price level; see Romer
(2000) for some advantages of this approach. Given the developments in the financial
markets, following their liberalisation, and the proliferation of near moneys, the demand
for money and LM curves are found to be unstable. Therefore, many central banks have
switched to targeting the nominal rate of interest instead of the money supply. It is well
known that if LM is unstable, targeting the nominal rate of interest results in fewer
fluctuations in economic activity and, if IS is unstable, the money supply should be
targeted; see Poole (1970). Therefore, in the RTM derivation of AD from ISLM, r is
treated as an exogenous policy variable, and we shall denote this as r and the real money
supply will be an endogenous variable, since the central bank cannot control both. Solving
+
equations (1)–(5) for Y and (M/P), as P or P are exogenous in ISLM, gives
+
ðc0 þ i0 Þ  c1 T  i1 
r þ i1 P þG
Y¼ ð6Þ
ð1  c1 Þ
 n o
M 1 +
¼ l0 þ ðc0 þ i0 Þl1  c1 l1 T ½ð1  c1 Þl2  i1 l1 r þ i1 l1 P þl1 G ð7Þ
P ð1  c1 Þ
Note that LM is redundant in this model, because the nominal rate of interest is now
exogenous. Equation (7), therefore, determines only the real money balances.
There are two problems with this approach. First, treating r as an exogenous variable
makes money and bond markets fix-price markets. Since goods and labour markets are also
fix-price markets, it is not clear how the interrelated all fix-price market model functions.1
Second, (6) implies that there is no downward sloping relationship between output and
inflation rate. In fact, this relationship is positive, implying that, when the economy
experiences a shock, a change in the inflation rate works as a positive feedback mechanism,
and not as the negative feedback implied by the textbook ADAS models. This is intuitively
obvious since, following a deflationary shock, if the rate of inflation falls, the real rate of
interest increases (for a given nominal rate of interest) and investment expenditure
declines, further increasing the effects of the deflationary shock.
+
To get an AD—with a negative relationship between Y and P and to give an impression
that price adjustment performs its traditional negative feedback function—a monetary
policy rule (MPR) is imposed such that the central bank adjusts the targeted nominal rate
of interest by a larger proportion than the change in the inflation rate. RTM use such
a MPR to derive their AD curve and its derivation can be explained by adding an additional
+
relationship: r ¼ (1 þ a) P where a is a positive fraction. Substitution of this for  r in (7)
+
makes the coefficient of P negative and equal to – i1a/(1 – c1).
There are some problems with this approach. First, in the absence of a discretionary
policy, e.g., MPR, price adjustment cannot restore full employment equilibrium by itself.
Second, it is not only this MPR but any other discretionary demand management policy
that can be used to restore full employment to change the inflation rate. Therefore, there is
no need for a downward sloping AD, because other discretionary policies work by shifting
this AD. The point is that, if an appropriate discretionary policy is not implemented,
equilibrium cannot be restored through price adjustment. However, with a MPR or with
a similar policy, price adjustment can only speed up the adjustment process. Third, there is
1
We thank a referee for pointing out these problems.
The ADAS model 419

Fig. 1. The Romer—Taylor Model

no guarantee that central banks will continue targeting interest rates forever, once the ef-
fects of financial innovations are stabilised and LM becomes more stable. Therefore, the
downward-sloping AD in this ADAS model is a transient relationship. Fourth, it is the
change in the real rate of interest, induced by MPR, or some other discretionary policy, not
price adjustments through demand and supply interactions, that can take the economy
towards full employment equilibrium. Finally, to achieve an increase in the real rate of
interest, if a substantial increase in the nominal rate is necessary, it could be politically
costly because of substantial increases in mortgage payments by householders.
It is well known that, if the goods market is a fix-price market, it implies that firms are
constrained by demand. Therefore, it is conceptually meaningless to derive a supply curve,
as it does not exist. Nevertheless, several textbooks have derived upward-sloping AS
curves. RTM avoid calling such a relationship the AS curve. Instead, they call it an inflation
adjustment function (IA). It may be based on the mark-up principle in which, if the unit
cost of production is mildly pro-cyclical, IA would have a positive slope. But RTM use
a horizontal line for IA. However, they explain why firms do not adjust their pricing policies
quickly: it is partly owing to the well-known explanations based on implicit contracts,
staggered wage and price setting practices and menu costs etc. This implies that, when
firms decide to change their prices, IA shifts and a new equilibrium is established.
Although RTM’s IA can be replaced with an upward-sloping goods market Phillips curve
without causing any major change in the working of their model, we shall accept that IA is
+
horizontal in ( P ; Y ) space.
For illustration we assume in Figure 1 that, initially, output (Y0) equals full employment
output ðY Þ and the rate of inflation is P0 : A deflationary shock, say due to a deterioration in
+

investor expectations, decreases the autonomous component of investment, i0. The


reduced form ISLM equation (6), which is shown as ISLM Y0, shifts to the left to ISLM
Y1. In the short run, there is no immediate change in the pricing policies, and equilibrium
output Y0 falls to Y1. If prices are adjusted downwards, IA shifts down from IA0 to IA1. In
the absence of a reduction in the nominal rate of interest, the real rate of interest increases,
causing a further reduction in demand and output to Y2. Even if an upward sloping ‘AS
look-alike’, IA is added to this model, price changes will accentuate the problem.
Therefore, discretionary policies, e.g., a more than proportionate reduction in the nominal
rate of interest and/or an increase in government expenditure (or even an increase in money
420 B. Bhaskara Rao
supply), are necessary to stimulate demand and output. There is nothing in this so-called
Keynesian system, based on the ISLM model, to bring the economy back to full
employment through market mechanisms and price adjustments.

4. An alternative derivation of AD
We have ignored so far a widely used traditional textbook approach to the derivation of AD.
In this approach, no distinction is made between the real and nominal rates of interest.
Therefore, the interest rate in the investment and demand for money functions is just r.
The reduced form income equation from the ISLM model shows that Y depends on real
balances. Therefore, by assuming higher values for the absolute price level, and ignoring
what may happen to the real rate of interest in this process, the LM curve is shifted
upwards. The result would be a decline in Y and an increase in r. Thus this negative
relationship between P and Y is said to be the elusive AD curve. This derivation is well
known, and there is no need for further elaboration. However, if a distinction is made
between the real and nominal rates of interest, it is hard to establish, a priori, that AD is
downward sloping in the inflation–output space.
The relationship between inflation and output can be derived by making a minor change
to the investment and demand for money functions as follows.
I ¼ i0  i1 ðr*Þ ð3aÞ
 
M +
¼ l0 þ l1 Y  l2 ðr* þ P Þ ð5aÞ
P
where r* is the real rate of interest. The reduced form income equation, after defining
+
P ¼ (1 þ P ) 3 P–1, of equations (1), (2), (3a), (4) and (5a) is
 " #
1 + i1 MP1 Þ
Y ¼ ðc0 þ i0  l0 i1 Þ þ l2 ðc1 T þ G þ i1 P Þ þ + ð8Þ
ð1  c1 Þ þ i1 l1 ð1 þ P Þ
+
Differentiating (8) with respect to P gives:
!
@Y MP1
+ ¼ i1 l2  + 2 Oðð1  c1 Þ þ i1 l1 Þ ð9Þ
@P ð1 þ P Þ
Thus a negative relationship between Yand P exists only if l2 > [(MP1)/(1 þ P )2] [ (M/P) 3
+ +

(P1)2. Needless to say, this is somewhat implausible given that estimates of l2, the
coefficient of the rate of interest in the money demand function, are generally small
compared with (M/P) 3 (P1)2. Therefore, a positive relationship between Y and P is most
+

likely, implying that, generally, the real rate of interest declines in inflationary periods. And
this is not far from the truth, because inflationary adjustments to the nominal rate of interest
are a more recent phenomenon.

5. Conclusions
This paper explained that Hick’s ISLM model is a model of three interdependent markets
of goods, money and bonds. In the textbook ADAS model, AD derived from ISLM is not
a demand relationship. Similarly, AS derived from the labour market, ignoring the
implications of the fix-price nature of the goods market in ISLM, is not a supply
The ADAS model 421
relationship. Therefore, the impression given by ADAS that it is a single aggregate goods
market model and a synthesis of Keynesian and neoclassical models is misleading. While
ISLM has some Keynesian features, e.g., persistence of unemployment, which is not easily
correctable through a flexible price mechanism, Hicks admits that it is essentially Walrasian
in spirit. Therefore, care should be exercised in claiming that ISLM is truly a Keynesian
model.
Although there are three alternative derivations of ADAS, none of them is conceptually
satisfactory. They give the misleading impression that, if only wages and prices are flexible,
the economy can attain full employment equilibrium through the market mechanisms.
Even in the RTM model where prices are set and changed by firms, discretionary policies
are necessary to move the economy from an under-employment equilibrium to its full
employment equilibrium.
A major implication of this paper is that models of the economy, where market
mechanisms ensure full employment output, should not include an AD curve based on the
ISLM model, as this is not consistent with other parts of such models. Classical and
neoclassical models which avoid this inconsistency have been adequately explained in the
textbooks, e.g., Ackley (1961) of the early 1960. The adequacy of this type of model in
comparison with the rival ISLM model, in which output is determined by aggregate
demand, may be tested using the non-nested hypothesis tests, such as those developed by
Pesaran (1982). Although the existing evidence favours the Keynesian model, further
empirical work is desirable. Nevertheless, it may be said that the current belief that ADAS
is a synthesis of the Keynesian and neoclassical systems, like the earlier belief that ISLM is
a synthesis of the Keynesian and Monetarist models, is untenable. The ADAS model
ignores the main implication of ISLM that unemployment could persist and does not
respond to flexible prices. The sooner the textbooks correct these faulty expositions the
better will be our insights into the working of real-world economic systems.

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