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AD/AS: a suggested interpretation

Summary:
Many macroeconomists don't like the Aggregate Demand/Aggregate Supply framework often used in Introductory macro textbooks. Maybe that's because it isn't explained properly. So I am going to explain it my way. If you explain the AD/AS framework my way, you will see that it portrays a deep and realistic understanding of macroeconomics that is lost in more "sophisticated" models. If you don't start with the AD/AS framework you are doing it wrong. The AD/AS framework is useful for thinking about monetary exchange economies. If you are talking about a barter economy, or any sort of economy where people do not use a medium of exchange ("money") to buy and sell all other goods (and assets), then the AD/AS framework is not useful. But that is not realistic. Money (as medium of

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Many macroeconomists don't like the Aggregate Demand/Aggregate Supply framework often used in Introductory macro textbooks. Maybe that's because it isn't explained properly. So I am going to explain it my way.

If you explain the AD/AS framework my way, you will see that it portrays a deep and realistic understanding of macroeconomics that is lost in more "sophisticated" models. If you don't start with the AD/AS framework you are doing it wrong.

The AD/AS framework is useful for thinking about monetary exchange economies. If you are talking about a barter economy, or any sort of economy where people do not use a medium of exchange ("money") to buy and sell all other goods (and assets), then the AD/AS framework is not useful. But that is not realistic.

Money (as medium of exchange) is different from all other assets. There is a flow of money into our pockets (and bank accounts) whenever we sell any other good (or asset). And there is a flow out of our pockets whenever we buy any other good. And so there are two ways an individual can increase the stock of money in his pocket over time: he can increase the flow in; or he can decrease the flow out. But what is possible for each individual may not be possible for all individuals, because one person's flow out is another person's flow in.

Because there are two flows of money (a flow out and a flow in), there are two equilibrium conditions. The AD curve (or AD function) is the equilibrium condition for the flow out (when we buy goods with money). The AS curve (or AS function) is the equilibrium condition for the flow in (when we sell goods for money). The economy is at a point on the AD curve when the actual flow out equals the desired flow out. The economy is at a point on the AS curve when the actual flow in equals the desired flow in.

Then remember that exchange is voluntary, so that actual quantity traded is whichever is less: quantity demanded; or quantity supplied. So actual Y=min{Yd(on the AD curve);Ys(on the AS curve)}. And remember that prices are sticky, so if one of the curves shifts quickly the economy will be at a point off (at least) one of the two curves. And you might want to draw a third curve that illustrates price stickiness (but don't call it a "SRAS curve", because it isn't). And remember that whether the economy ever actually approaches the AD/AS intersection ("full-employment equilibrium") is an open question that must be addressed by macroeconomists, and the answer to that question will depend on many things, the most important of which is the monetary system or monetary policy regime. [Update: Because it is easy to imagine a monetary policy regime which makes the AD curve never cross the AS curve, or slope the wrong way.]

A good simple place to start would be with MV=PY for the AD curve, holding both M and desired V constant. Because it forces us to think about both stocks and flows of money. Then go on to make M and V endogenous, if you wish. (A still better place to start would be with MV=PT, because monetary recessions disrupt all trade (T) and not just trade in newly-produced goods (Y), but that's an argument for another day.)

And if you don't start with money, monetary exchange, and AD and AS, you are doing macro wrong. Because the only thing that makes macro different from micro general equilibrium theory is the fact that macro incorporates the fact of monetary exchange, which microeconomists ignore.

In particular, if you start with saving investment and interest rates you are doing it wrong. And if you start with Y=C+I+G+NX you are not even wrong.

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