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.