How Complicated Does the Model Have to Be - Essay Example

DRAFT Aggregate demand is a schedule or curve that demonstrates the quantity of real output that the buyers together wish to buy at each of the pricelevels that are possible. The relationship between the price level that has been measured by the gross domestic product price index and the quantity of the real gross domestic product that is demanded is inverse or negative which means that when the levels of the prices experience a rise, then the amount of real gross domestic product that is demanded decreases and when the price levels go down, then the real GDP that is demanded will record an increase. While there has been a substantial quantity of theorizing and empirical work over the constituents of the aggregate demand, consumption spending has definitely been the core of or related research and debate and the history of the debate is as familiar as that of the aggregate supply wars. It started with the Keynesian consumption function which perceived consumption simply as a function of the disposable income but consequently this function encountered some experiential inconsistencies (Krugman, 2000, p. 39) In the AS-AD model, the aggregate supply curve and the aggregate demand curve are applied together so that they can be used collectively in the analysis of the economic fluctuations. This model brings together the short-run aggregate supply curve and the aggregate demand curve which then means that the point that they cross is the point that represents the short run microeconomic equilibrium where the quantity of the aggregate output that is demanded is the same as the quantity of the aggregate output supplied (Krugman and Wells, 2006, p 256). The aggregate supply curve is used to demonstrate the relationship that exists between the aggregate price level and the quantity of aggregate output that is supplied. Therefore the short-run aggregate supply curve is therefore employed when showing the connection that exists between the aggregate price level and the quantity of aggregate output supplied that is there in the short-run while considering the time period when many of the production costs can be taken to be constant. In respect to macroeconomics, the short run is considered to be the period of time that is characterized by the output prices being flexible but the input prices are completely fixed or not very flexible and the short run begins after the immediate short run has ended. These assumptions that are associated with output and input prices are broad and they are therefore connected to the in the aggregate. Certainly, various input prices are more flexible than others. For example, the prices of petrol are generally flexible which means that a company that uses petrol as an input will definitely have at least one flexible input price. Conversely, wages at the same company are determined by labour contracts that after negotiations may be in place for a number of years and therefore since the wages can be considered to be the largest and most important input cost, then it is the case that, generally, the company faces input prices that are not flexible for several years at a time. Therefore in the short-run, during which the company might be able to change the prices that it charges its customers to give them the services that they offer but during which it must contend with noticeably fixed input prices is in essence quite long. In the short-run aggregate supply curve the aggregate supply slopes in the upward since as a result of the input prices being fixed, any changes that are made to the to the price level will mean that there will be an increase or a decrease in the real company’s profits. The immediate short-run aggregate supply curve, the short-run aggregate curve and the long run aggregate supply curve are all very significant as each curve is suitable to the circumstances that match its particular assumptions about the flexibility of input and output prices. Contrary to what most of the critics argue, the AD-AS model is both internally consistent and also conforms to the analysis that is provided was developed by Keynes while the heterogeneous approach to the behavioural foundations permits the model to consider the aggregation problems as well as evidence that is derived from the behavioural economics. The AD-AS model looks at the economy as a general in that the theory is more overall rather than fractional while giving a practical illustration of the analytical frame that is behind the fixed wage general equilibrium. The strength of the Aggregate demand- aggregate-supply model is particularly the obvious attempt at integrating the analysis of goods, labour and the financial markets. The model generally splits the economy into two distinct sections which are the demand section and the supply section and then scrutinizes their interaction using accounting identities, the symmetrical conditions and behavioural and institutional comparisons. The demand sector characteristically looks at the characteristics that relate to the demand for goods as well as the demand and supply of assets while the supply sector normally examines the factors that are connected the output and pricing decisions of the producers and the factor markets. This model makes sure that neither the demand nor the supply sectors’ characteristics are disregarded I its analysis and that the microeconomic outcomes be determined by the interaction that exists between the different markets. The specific segregating in to aggregate demand and aggregate supply along with the choice of words that is used to refer to them might be a source of the academic benefit of making microeconomic analysis possible in relation to the same tools as the microeconomic models that are considered to be simple. This benefit though can be said to be achieved at a high price since the aggregate demand and supply curves symbolize composite relations and they definitely do not resemble the microeconomic curves which adopt a fractional view of the economy. The model has many weakness and limitations that are clearly known. There has been a lot of criticism about how the model does not encompass the microeconomic foundations and that the model is too mechanical and does not really consider situations that may be uncertain and expectations in a manner that is serious. It is also stated that the same model leaves out many vital characteristic of reality and some of the implications that arise from it are not consistent with empirical observation. For example, the assumptions of flawed competition should replace competition and the supply of money is not supposed to be treated as an exogenous variable in an economy that is characterized by modern monetary establishments. The consumption function is also supposed to take into consideration the income distribution effects that affect consumption, the increases that are recorded in the aggregate demand should be able to provide a direct stimulus to investment, and the difference that exists between the nominal and the real rates of may be serious. These modifications among others may have the effect of making the model complicated and consequently affect some of the attributes that are identified with it but is should be remembered that in principle, their introduction is direct and the model that comes out of it can still be depicted with the AD and AS curves. The simple form of the model predict a movement that is counter-cyclical when considering the real wage and this implication that finds very little support in the data is no longer viable in the versions of the model that are characterized by competition that is imperfect and a degree of combination of non-diminishing returns to labour or a counter-cyclical pattern that is in the profit margin. There is also another set of problems that with the AD-AS models that highlights the unsatisfactory treatment of dynamics whereby there is an obvious lack of integration that exists between the analysis of the short-run and the issues that are more long-run and in the case of the handling of the short run issues, the analysis always depends on the unspecified or the assumptions that are doubtful that concern the process that leads to a short-run Keynesian equilibrium. The limitations that are related to the simple AD-AS model in terms of the dynamics may be a legacy of Keynes’s own emphasis on the short-run equilibrium as the assumption of the fulfilled expectations made possible the presentation of the fix-wage general equilibrium. The model does not consider addressing the issue of stability and it works with the money wage the same way that it is presented. This though can be extended in a manner that will make it have the conventional implications whereby unemployment is able to exist in the model since the money wage is exogenously constant, if the money wage is allowed to decrease as a response to the presence of unemployment, the aggregate supply curve will show a shift downwards. Still considering the textbook implications, an expansion of output and employment will be experienced along the negatively sloped aggregate demand curve and this will move the economy to the natural rate of unemployment. The explanation that is behind this kind of adjustment is the Keynes effect whereby a reduction in the wage and the price will generally mean that there is an increase in the real supply of money while the interest rate decreases and as a result there is an increase in the investment and aggregate demand. This effect is able to be augmented by the real balance effect which is needed to enable the real balances to directly stimulate the aggregate demand for the goods. This analysis can be seen to be in conflict with Keynes’s own argument which insists that involuntary unemployment cannot be eliminated by the increased flexibility in the wealth and the decrease in the money wages will affect the economy in several ways but at the same time is likely to motivate the output. Although the analysis by Keynes’s of the effects of the changes that are related to money wages may be considered to be sketchy, the logic that is behind the possible instability can be considered to be flawless. The actual balance effect was overlooked by Keynes but been discovered to be empirically unimportant and the expansionary implications of a decrease in the money wages due to the Keynes effect may be more than offset by the antagonistic influences that are related to debt deflation, the distributional shifts and the expectations that are supposed to come from the on-going reductions of wages and prices. The complicating factors that are associated with this model can be addressed by a discussion that is informal that will be aimed at understanding the diverse effects of money wage changes and employing the AD-AS model as a starting point. The debt deflation problems have the ability to make the AD-AS curve upward looking and besides money wage reductions have the ability to shift the AD curve towards the left as a result of a higher tendency to consume out of wage income as opposed to non-wage income. Both of these situations prevent the economy from converging to the optimum level of output and the analysis therefore can be made more accurate by including particular effects into more common Keynesian models so that the stability can be more formally looked at. Bibliography Krugman, P. 2000. How complicated does the model have to be?. Oxford Review of Economic Policy, 16 (4), pp. 33--42. Krugman, P. R. and Wells, R. 2006. Macroeconomics. New York: Worth. Read More