Aggregate Demand and Aggregate Supply Model*

by Montree Patthamadilok

Recently, the aggregate demand and aggregate supply model has been criticized by some economists for being used incorrectly to explain the macroeconomic model; Barro and Geithman (1994). The authors of this study, Lila J. Truett and Dale B. Truett (1998), argue that the usefulness of the aggregate demand (AD) and aggregate supply (AS) model can be better explained if the AD is defined consistent with the ISLM model and the AS is defined consistent with the equilibrium in factor markets. When these definition are used, it is useful to show the fundamental differences of classical and Keynesian perspectives. The aggregate demand is defined as the relationship between the real quantity demanded for the final goods and services and the price level. The AD curve represents the set of coordinate points that represent equilibrium point in the Keynesian-cross model. The downward slope of the AD curve has been justified by the real balance effect and the interest rate effect. The real balance effect occurs because a decrease in the general price level increases the real wealth of people owning financial assets (loans, stocks, bond, and etc). The interest rate effect occurs because as prices fall, the quantity supplied of money in real term excess the quantity demanded. This leads to a fall in the interest rate and a rise in quantity demand of consumption and investment. The aggregate supply is defined as the relationship between the real quantity supply of final goods and services and the general price level. Underpinning this definition of AS is the assumption that relative input costs and output prices are adjusted so that no excess supply or demand for factor of production at any point on AS curve. So AS curve is the factor-market equilibrium curve. The long run AS curve may be argue to be upward slope due to the real balance effect. As price rise, the real wealth of financial assets falls, so the people who hold those assets are willing to work more. The reverse effect occurs when price fall, people are willing to work less due to increasing in their wealth.
     The classical model told that flexible product and input price will change response to either shift in AD curve or AS curve which lead to the new equilibrium in both market. It is important to note that based on the underpinning of AS curve, the input markets are still at equilibrium. The keynesian model argues that there is price rigidity at some level, including in labor market, so that the new equilibrium cannot be reached in the short-run and the disequilibrium situation occurs. If price is prevented from falling, producers must reduce the new quantity produced to avoid to excess inventory, although they are willing to supply  larger quantity at the prevailing price. The result is that quantity actually supplied equal to quantity demanded in final good and services market, but the quantity demanded is less than quantity supplied in the model, which imply that disequilibrium occurs in labor market when the demand for labor in the labor market fall and some workers are laid off, but the wage rate is not adjust to the new lower equilibrium. In this case, the involuntary unemployment occurs. The reasons that make price rigid include oligopoly in output market, union labor, efficiency wage theory, and etc.
     The related issues from the policy perspective consisted of three topics. First, how long it will take to readjust to the new equilibrium situation. Second, how the nature and magnitude of the social cost of involuntary unemployment is during transition period and possible solution to solve this problem. The last after a decrease in AD, the AD and AS curves do not intersect at any positive aggregate price level. The authors also suggest that the recently advance macroeconomic theories involving dynamic path adjustment concerning with the impact of lack of information and inaccurate expectation, for example the imperfect market coordination model, represent a blending of Keynesian and classical positions.

*American Economist, Spring 1998 v42, pp. 71-75.