INTRODUCTION TO AD-AS MODEL

• Keynes assumed that price level remained constant in his theory of income and employment.
• Keynes’s macroeconomic analysis focused on aggregate demand and aggregate supply related to national income.
• His approach was concerned with an economy in depression, characterized by demand deficiency and excess capacity, leading him to assume a constant price level.
• Classical economists believed that national output or income was determined by real factors like capital stock, technology, and labour supply, not by the general price level, which was determined by the quantity of money.
• This classical view is known as classical dichotomy.
• The AD-AS model (Aggregate Demand-Aggregate Supply model) highlights the breakdown of classical dichotomy by explaining the determination of income and employment with a flexible price level.
• The AD-AS model is used to explain fluctuations in output, price level, and inflation rate in the economy.
• The model helps explain how the interaction between aggregate demand and aggregate supply jointly determines aggregate output (i.e. real GDP) and the general price level.

Aggregate Demand (AD)

• Aggregate demand is the total desired quantity of goods and services bought by consumer households, private investors, government, and foreigners at each possible price level, holding other factors constant.
• Aggregate demand is not a quantity demanded at a specific price but a schedule of total output demanded at various price levels, represented by a curve.
• The four components of aggregate demand are: consumption demand, private investment demand, government purchases of goods and services, and net exports.
• The aggregate demand curve depicts the total output of goods and services that households, firms, and the government are willing to buy at each possible price level.
• The curve shows the relationship between the total quantity demanded of goods and services and the general price level.
• The aggregate demand curve (AD) differs from the ordinary demand curve of an individual commodity in microeconomics, although both slope downward to the right.
• For an individual commodity, when its price rises, it tends to be substituted by close substitutes, leading to a fall in the quantity demanded.
• The slope of the demand curve of an individual commodity depends on the substitution between commodities, but the slope of the aggregate demand curve is influenced by factors different from those affecting individual commodity demand.
• The AD curve slopes downward to the right, as shown in Figure 10.1, where the horizontal axis represents aggregate output and the vertical axis represents the general price level.
• The AD-AS model is different from the market demand-supply model in microeconomics, as it does not consider resource reallocation between products when prices change in individual markets.
• In macroeconomics, the focus is on the determination of aggregate output and the total employment of resources in the economy, not on relative prices of various products.
• The AD-AS model studies the determination of the general price level rather than the relative prices of individual goods.
• The upcoming sections will explain the concepts of aggregate demand (AD) and aggregate supply (AS) curves, their shape, and the factors that determine them, as well as discuss important controversial issues in macroeconomics.