Wednesday, June 5, 2013

Guest Post: The Logical Inconsistencies of AS-AD

Although I stirred up the dust a bit with my previous posts on AS-AD, I tried to avoid debating the overall merits of the model(s).  I was interested in why AS-AD is more prominent in the textbooks than in other venues, like the blogosphere and policy analysis.  But the desire for a red-blooded debate is out there!  Here is a guest post from Fred Moseley of Mt. Holyoke College that lays out his view that AS-AD should be chucked altogether.

Get Rid of AS-AD, by Fred Moseley


I think that AS-AD is a very bad model, that we should not be teaching to our students, for the following reasons:

1. It is logically inconsistent outside of equilibrium. The AS and AD curves do not refer to separate economic agents making separate decisions about S and D (as consumers and firms in microeconomics), but instead refers to different theories of the relation between output and the price level in the same economy. Outside of equilibrium, these two different theories predict two different levels of output for the same price level; but the same economy cannot produce two different levels of output at the same time.

There are different theories of AS, but all of them are logically inconsistent with the AD curve outside of equilibrium. The original AS curve in the 1970s was derived from the classical labor market. The AD curve, on the other hand, was (and is) derived from the Keynesian IS-LM theory. Thus, the AS-AD model attempts to reconcile Keynes’ theory (in which employment is determined in the output market) and the classical theory (in which employment is determined in the labor market). Keynes must be shouting out from his grave: “No, don’t do it! This is absurd!”

More recent AS curves (e.g. Mankiw’s “sticky price” model) turn AS into a price, which is a function of output, and which thus contradicts AD which is a quantity of output as a function of P.

2. Because of the logical inconsistency between AS and AD, the model cannot explain the adjustment process to equilibrium. For example, in the case of excess supply, the AD curves implies that output should increase in order to restore equilibrium and the neo-classical AS curve implies that output should decrease in order to restore equilibrium. But the output of the same economy cannot both increase and decrease at the same time.  In the “sticky price” model, AS > AD has no meaning, because AD is a quantity and AS is a price.

3. The AS-AD model is empirically unrealistic. The model predicts that AS > AD causes prices to fall, but prices have not fallen since the 1930s (more than a percent or two once or twice). And it is a very good thing that prices no longer fall! Because significant deflation would be a disaster for such a heavily indebted economy as the US. And yet the AS-AD models in the textbooks still present deflation as an unproblematic solution to excess supply. Ben Bernanke, in his real-world job as Chairman of the Fed, is doing everything he can possibly think of in order to avoid deflation. And yet his intermediate macro textbook (co-authored) still presents the AS-AD model and deflation as a solution to excess supply.

David Colander was one of the first to call attention to these deficiencies of the AS-AD model in a very interesting and important 1995 JEP article entitled “The Stories We Tell: A Reconsideration of ASAD Analysis” (9, 3: 169–188.)

We should not be teaching such a logically contradictory and empirically unrealistic to our students. It encourages sloppy thinking and memorization, rather than rigorous and critical and creative thinking.

Mankiw concludes Part 4 of his textbook (on short run fluctuations) as follows:
If you find it difficult to fit all the pieces together, you are not alone. The study of aggregate supply remains one of the most unsettled – and therefore the most exciting – research areas in macroeconomics. (emphasis added)
I argue that the reason why so many students (and professors as well) “find it difficult to fit all the pieces together” is that the pieces do not fit together logically! The pieces – the AD and AS curves – are mutually contradictory. It is not only that the theory of AS is unsettled, but more fundamentally that all the theories of AS are logically inconsistent with the Keynesian ISLM theory of AD with which it is combined.

The fact that students “find it difficult” is a good sign, not a bad sign. It is not a sign that students are not smart enough for the theory, but rather that the theory has serious logical problems, and that students are smart enough to have an intuition about these problems, even though they usually cannot fully identify and articulate them.

One is reminded of Colander’s “precocious student”, who asks probing questions about the inconsistencies between the ISLM model and the ADAS model, and does not receive satisfactory answers from a back-peddling professor, and she decides to switch to another major.

For further discussion of these issues, see my critique of Mankiw’s presentation of the AS-AD model in “Critique of Aggregate Demand – Aggregate Supply: Mankiw’s Presentation”, Review of Radical Political Economics, 2010; vol. 42, 3, pp. 308-314.

4 comments:

Edward Lambert said...

...comment posted on mainly macro too...

We can combine the Phillips curve with the AS-AD model into a new model... the Aggregate supply - Effective demand model (AS-ED). Here is a preliminary post of the model...
http://effectivedemand.typepad.com/ed/2013/06/proof-of-effective-demand-incorporating-unemployment-and-nairu.html

The equation for effective demand gives the spare capacity available between real GDP and the LRAS zone. When the spare capacity is used up, the dynamics of the Phillips curve kick in.
Through the equations for the limits of effective demand, the AS-ED model (aggregate supply - Effective demand) gives economic constraints that are missing from the AS-AD model.
Case in point, when the crisis hit, the price level of effective demand (on the AS-ED model) shot up to almost 30%, while inflation at aggregate supply fell to 2%. There was a huge separation between the effective demand and aggregate supply curves.
The effective demand curve behaved like a normal demand curve should. As output dropped, demand rose for that lower output. Also, for that lower inflation rate, there was more demand for output by following the inflation line out to the effective demand curve.

What was the effective demand curve telling us that the aggregate demand curve wasn't?

1. The effective demand curve was giving a measures of spare capacity and low input use.
2. As output declined, interest rates declined, saving increased, leading to a decrease in the demand for liquidity. The effective demand curve was revealing unsatisfied demand, in other words... "effective demand".
3. The effective demand curve was revealing that a price level of 30% would have been paid for such low output, since the market was not clearing appropriately with full-employment (a measure of dead-weight loss to society).
4. The crossing point of the effective demand and the aggregate supply curves showed the equilibrium price level and output if productive capacity held constant, there were suddenly "full employment" of available labor and capital (within the constraints of effective demand) and unit labor costs rose in par with the price level.

Real GDP is always on the aggregate supply curve. The full-employment constraint is on the effective demand curve. When there is excess demand (effective demand), factor inputs do not compete to cause inflation.
The US currently shows a real GDP limit of $14.100 trillion if inflation does not change and productive capacity is increased with available labor and capital (within the limits of effective demand)... approx. $400 billion more in real GDP before spare capacity is used up and inflation pressures start to mount.

All the above principles show that the AS-ED model is more useful and logically better than the AS-AD model for assessing economic dynamics.

ashokarao.com said...

Peter, very interesting post. I have a reply to your initial post and I think it concerns this one as well, here: http://bit.ly/10Jl4MX

AD-AS is a very good heuristic, and to the extent we're trying to understand policy and not predict anything, it's very good.

And, much of your criticism can be addressed (if not "solved") if we think of the y-axis as inflation rate rather than price level.

The AD-AS framework is ambiguous in the sense that we can draw many arguments for it. For example, demand crashed predicting deflation (since prices are less sticky than wages). However we've still had 1% inflation. We can therefore deduce AS has contracted a bit. (There are many good arguments why technological change slows price growth... Don't restrict yourself to price level, rather inflation. AS shocks are a great example of the inflation targeting's weakness).

But it can similarly be argued from AS first; that the shale boom should increase AS, but prices are rising, so AD must not have fallen as rapidly as possible. etc.

Peter Dorman said...

I'll let Fred be the one to response to comments on his post, but I'd like to say one thing from the perspective of a teacher: any model that encourages students to think that "wages" and "prices" refer to different things is a dangerous item to place in front of them. Wages *are* prices. And nominal incomes, of which wages are the largest component, *are* nominal expenditures in a closed system. Understanding this is something like 50% of "getting" introductory macro. Of course, one can argue (empirically) about relative price changes, the distribution of income and the composition of demand, but please don't let it confuse the central issue. AS-AD practically invites students to un-get macro no matter how many caveats surround it.

Irene_J said...

Wonderful blog by Fred Mosley. They should really get rid of AS-AD. They are inconsistent.

regrads,
irene of Vacation Rentals in Seattle