Aggregate Supply Aggregate Demand Analysis A History

Aggregate Demand-Aggregate Supply Analysis: A History
Dutt, Amitava Krishna.

History of Political Economy, Volume 34, Number 2, Summer 2002, pp. 321-363 (Article)
Published by Duke University Press
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Aggregate DemandAggregate Supply Analysis: A History

Amitava Krishna Dutt
Aggregate demandaggregate supply (AD-AS) analysiswhich depicts the economy using an aggregate demand curve and an aggregate supply curve in a diagram with the price level and real output on the vertical and horizontal axes, and determines those variables at the intersection of those curves1 has a curious status in economics. On the one hand, it has emerged in recent years as the preferred method of teaching macroeconomics at the undergraduate level. It appears, and usually plays a central role, in almost all principles and intermediate macroeconomics texts.2 On the other hand, it is severely criticized by economists in their scholarly books and journals for being internally inconsistent, for failing
Correspondence may be addressed to Amitava Dutt, Department of Economics, University of Notre Dame, Notre Dame, IN 46556. An earlier version of this paper was presented at the session on aggregate demandaggregate supply models at the History of Economics Society meetings, Montreal, June 1998. I am grateful to Warren Young and to other participants in the session, to Sandy Darity, and to two anonymous referees of this journal for their useful and insightful comments and suggestions, as well as to Dennis Markov for able research assistance. 1. A different model, sometimes called the dynamic AD-AS model, which differs from the standard AD-AS framework by measuring the rate of ination instead of the price level on the vertical axis, is to be found in some textbookssee, for instance, Dornbusch and Fischer 1978, 40229. Although this model is not examined in this paper, to the extent that this dynamic AD-AS model shares some features with the standard AD-AS framework, some of what follows applies to it as well. 2. Principles texts are dened here as those that assume no prior study of economics on the part of the reader, generally keep algebra to a minimum, and use simple graphs. Intermediate texts usually assume that the reader has already been introduced to economic principles and make use of algebra and more complicated graphical analysis. History of Political Economy 34:2 2002 by Duke University Press.
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to adequately depict the operation of real economies (and perverting the true message of the Keynesian revolution), and for oversimplifying and leading to a conation of macroeconomic and microeconomic concepts. In fact, a growing chorus of critics recommends jettisoning the framework as a teaching tool (see Barro 1994, Barens 1997, and McCormick and Rives 1998 for recent indictments). The resolution of this puzzle is an important order of business, since it has an obvious bearing not only on how macroeconomics should be taught, but also on how the aggregate behavior of the economy should be understood. This article attempts to contribute toward this goal by examining the early appearance of AD-AS analysis and its subsequent spread to intermediate and principles textbooks. More specically, its purpose is to document the birth, diffusion, and growth in popularity of the analysis, and to trace when and how its alleged problems emerged. Before we turn to that, however, it is useful to review briey the nature and criticisms of AD-AS analysis. AD-AS Analysis and Its Criticisms Although the AD-AS framework appears in most principles and intermediate economics texts, it does not do so in the same form everywhere.3 Here I present what is arguably the most popular version, which I call the basic model, conning discussion of other versions to brief comments.4 I rely more on intermediate texts for an explicit derivation, since principles texts do not normally derive the AD and AS curves in detail. The equations of the basic model are shown in table 1. The AD curve shows the equilibrium levels of real output and price level that clear goods and asset markets. It is derived from equations (1) through (5) by nding the level of output for different levels of the price. As the price level increases, the LM curve (derived from equations (4) and (5)) shifts upward in r-Y space, intersecting the IS curve (derived
3. I will use the term framework or analysis to refer to the set of all models that use AS and AD curves to determine Y and P , and AD-AS model to refer to a specic model that uses the AD-AS framework. 4. I will not cite individual works that present the more popular versions, referring to only those containing less common features. Also, throughout this essay I conne my attention to the case of the closed economy. Models for the open economy contain, in addition to the AD and AS curves, a BP curve showing the relationship between price and output consistent with balance-of-payments equilibrium. Our discussion clearly has relevance for many elements of the open-economy models.
Dutt / AD-AS Analysis
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Table 1 Equations of the Basic Model

Equations Y =C+I +G C = C(Y ), 0 < C < 1 I = I (r), I < 0, L = L(Y, r), L1 > 0, L2 < 0 M/P = L Y = F (N), F > 0 W/P = F (N) W = W0 Symbols Y = real output or income C = real consumption I = real investment r = rate of interest G = real government expenditure, exogenously given L = demand for money in real terms M = nominal stock of money supply, exogenously given P = price level N = labor employed W = money wage, with W0 its exogenously given level (1) (2) (3) (4) (5) (6) (7) (8)
from equations (1) through (3)) at a lower level of output (and a higher interest rate), implying a downward-sloping AD curve. A higher price level reduces the real money supply with an exogenously given nominal supply of money, increases the rate of interest, curtails investment demand, and, through the multiplier effect, reduces aggregate demand and real output. This effect has come to be known as the Keynes effect. Although not all texts are explicit about it, those that discuss the dynamics assume that departures from the AD curve cause rms to adjust output at given prices in response to excess demand and supply in the goods market (the money market always being assumed to clear). Some presentations also include the real balance effect: a rise in the price level reduces the real value of monetary assets, reduces consumption (and possibly investment), and hence reduces aggregate demand. This can be represented by replacing equation (2) with C = C(Y, M/P ), 0 < C1 < 1, C2 > 0. (2a)
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This modication makes the IS curve shift to the left when the price level rises, so that the AD curve remains negatively sloped. Although the AS curve is less standardized, one that is widely used assumes prot-maximizing behavior by rms operating under perfect competition. Given the money wage, the stock of capital, and the production function (embodying given technologies), which reects diminishing returns to labor, a given price level is associated with a protmaximizing level of output. The AS curve is obtained, given the money wage, by nding the level of output rms produce at each price level: a higher price level implies a higher level of employment and output given diminishing returns to labor, so that the AS curve is upward-rising. Formally, the curve is derived from equations (6) through (8). A variant, making the money wage a rising function of the level of employment,5 obtained by replacing equation (8) with W = W (N ), W > 0, (8a)
also yields the upward-rising AS curve. Yet another version departs from the assumption of diminishing returns to labor with the assumption of a constant labor-output ratio, a, so that Y = N/a, (6a)
and from perfect competition by assuming that imperfectly competitive rms practice markup pricing, so that P = (1 + z)W a, (7a)
where z is the exogenously given markup.6 If W is xed in this formulation, so that (8) holds, the price level is xed by the pricing equation (7a), and the AS curve is horizontal.7 If, instead, we assume that equation (8a) holds, a higher Y implies a higher N from equation (6a), which implies
5. This relation between the level of the money wage and the level of employment is sometimes interpreted as an empirical relation (based on the Phillips curve) that shows how the level of the money wage depends on the condition of the labor market and not a standard supply curve of labor, which shows the quantity of labor supplied at each real wage (see Dornbusch and Fischer 1978). Some authors, such as Richard Froyen (1993, 22527), interpret the curve as a supply curve, taking price expectation to be given and making labor supply a function of the money wage. 6. See Dornbusch and Fischer 1994 and Blanchard 1997. 7. Horizontal (short-run) AS curves are used by Andrew Abel and Ben Bernanke (1992) and N. Gregory Mankiw (1992), among others.
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P A P 1 B E A Y Yf
Figure 1 The AD-AS model
S C F D
a higher W from equation (8a), which implies a higher P as shown in equation (7a), so that the AS curve is upward-rising. As shown in gure 1, the intersection of the AD and AS curves (the latter is drawn to be upward-rising) determines the equilibrium levels of Y and P at point E. Two implications immediately follow. First, the equilibrium level of output may well be less than the full employment level, shown in the gure by Yf (determined by labor demand and supply curves and the production function; the labor supply curve has not been included in the model). Second, if the money wage falls when there is unemployed labor,8 if the economy has unemployed labor the AS curve will shift downward and to the right. As long as the AD curve is downward-sloping, the equilibrium level of output will increase until the economy attains the full employment level, as shown in gure 2.9 Thus, in the short run (when the money wage is rigid) we can have unemployment, but in the long run (when money wage adjustments are completed) we have full employment.10
8. Or, in the case in which equation (8) is replaced by (8a), the wage function can be assumed to fall when there is unemployed labor. 9. Many recent presentations call the vertical Yf the long-run AS curve, reserving the term short-run AS curve for the curve I have called the AS curve. The short-run AS curve is sometimes assumed to be horizontal at low levels of output, then upward-rising, and nally vertical at the full employment level. Other presentations extend the short-run AS curve beyond Yf , as done in the text, to take into account phenomena such as overtime work. These variations do not change the essence of the story. 10. I assume, as is done in most standard AD-AS models, that the level of wealth held by wealth-holders (as well as the stock of capital) is held constant during this entire process.
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P A
S S'
L A A' Yf
Figure 2 Adjustment to full employment in the AD-AS model
Turning next to the criticisms of AD-AS analysis, A. A. Rabin and D. Birch (1982), T. Windsor Fields and William Hart (1990), Robert Barro (1994), David Colander (1995), and Amit Bhaduri, K. Laski, and M. Riese (1995) argue that the AD-AS model is internally inconsistent because it contains two very different theories of production and pricing. In their view, most treatments of the AD curve, which are derived from the standard textbook IS-LM model, assume that rms produce to meet demand by making quantity adjustments while keeping the price xed.11 In gure 1, with the price level at P1 , this theory implies that rms produce at B. The AS curve, when it is derived in the standard way, assumes price-taking behavior by rms, which maximize prots. In the gure, with price P1 , this theory implies that rms produce at C. Thus, for a given price level, the AD-AS model determines two different levels of output consistent with two different theories of production and pricing, making the model inconsistent. It should be noted that this criticism does not apply to the version of the model with imperfect competition, since in that model price-taking
Possible shifts in the LM curve (and hence in the AD curve) due to changes in wealth are ignored in this model. 11. This criticism is certainly not true of all versions of the IS-LM. William Darity and Warren Young (1995) examine many versions to show that there is a huge range of variations in the models and, in particular, that not all of them take the price level to be given. It does, however, apply to those presentationswhich, as we shall see below, are numerousthat explicitly take the price level to be exogenously given and assume that rms adjust output to meet demand, as in xed-price income-expenditure models and IS-LM models derived explicitly from them.
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behavior and prot maximization are not assumed, so that the second theory of pricing and production mentioned above is not invoked at all. Nor does it necessarily apply to the model with perfectly competitive pricing, since that model can be interpreted as follows. Given a price level expected by rms, say P1 (gure 1), prot-maximizing, price-taking rms produce at C, on the AS curve. Given this level of output, the price level varies to clear the goods market, which means that the economy will be at F , on the AD curve, where the goods and asset markets clear. Since the price level at F is different from the expected price P1 , rms will revise their expected price adaptively. This process of revision and adjustment will continue until the economy is at E, where price expectations are fullled and goods and asset markets clear.12 One can also assume rational expectations instead of adaptive expectations; the economy then instantly arrives at the equilibrium E. This interpretation of the model is not inconsistent since it does not use the xed-price quantityadjustment assumption. Thus, strictly speaking, only those versions that explicitly assume the xed-price quantity-adjustment assumption in deriving the AD curve can be faulted with inconsistency.13 However, since presentations that use the standard IS-LM model to derive the AD curve do assume that the price level is given in deriving their AD curve (without clarifying what variable adjusts to clear the market), they may also be said to be possibly inconsistent. A consistent presentation would need to derive the AD curve by drawing IS-LM curves on r-P space for a given Y , and then nding different levels of P for different levels of Y . Of course, the AD curve would formally be the same as the curve derived with P as the parameter. A second criticism of AD-AS analysis is that it fails to portray both the behavior of real economies and Keyness theory of output and employment adequately. Although this criticism is made in many forms (for instance, the analysis does not adequately capture the roles of uncertainty, history, money, and nancial institutions), perhaps the clearest way of expressing it is to note that the model implies that wage exibility necessarily implies full employment, and that short-run unemployment is due to wage rigidity (see Dutt 198687, Cottrell 1995, and McCormick and Rives 1998). This property follows from the fact that the AD curve is negatively sloped and that it does not shift downward when the wage
12. See Dutt 1997 for this interpretation of the AD-AS model. The interpretation is consistent with the Marshallian interpretation of Keyness theory; see Clower 1989 and Dutt 1992. 13. Some individual contributions that are arguably guilty of error will be discussed below.
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falls. In actual economies, however, greater wage exibility may in fact increase uncertainty and reduce aggregate demand, thereby exacerbating the problem of unemployment, as Keynes (1936) explicitly notes. Moreover, as I shall discuss below, Keynes suggests that for a number of reasons wage reductions may fail to stimulate, and instead actually depress, aggregate demand. The role of uncertainty, money, and nancial institutions in preventing wage exibility and wage reductions in bringing about full employment has also been stressed by post-Keynesians (see Dutt and Amadeo 1990b), and similar ideas have been expressed by mainstream Keynesians such as James Tobin (1993) and Frank Hahn and Robert Solow (1995). A third criticism is that in many presentations, especially in principles texts, the AD-AS analysis is oversimplied and leads to a confusion of macro- and microeconomic concepts. David Colander and Peter Sephton (1998) refer to this problem as dirty pedagogy. Since principles texts do not explicitly derive the AD curve from the IS-LM diagram and make the goods and asset market interactions behind its inverse slope explicit, they often give the mistaken impression that the AD curve is similar to the micro demand schedule, which shows quantity demanded at each price because of the substitution between goods and income effects of price changes (see Hansen, McCormick, and Rives 1985). These considerations should have no relevance for the AD curve, which deals with all goods and examines the effects of price changes given real income, and which shows equilibrium conditions in goods and asset markets. Early History of AD-AS Analysis Although Keynes 1936 did not develop or use the AD-AS framework discussed above, it is natural to start our narrative with this work, since the terms aggregate demand and aggregate supply functions appear in it and because the early macroeconomic models, including the AD-AS and others related to it, were developed explicitly to depict Keyness analysis. In chapter 2 of The General Theory Keynes denes the aggregate supply function as the relationship between the total value or aggregate supply price of the output, Z, which is the expectation of proceeds which will just make it worth the while of the entrepreneurs to give [a particular level of ] employment and the level of employment, N, given technology, capital stock, degree of competition, and the money wage (2425). Z rises with the level of N , since more output is produced with more
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employment and since higher N implies a higher price level, given diminishing returns and the given value of the money wage.14 The aggregate demand function is the relationship between D, proceeds which entrepreneurs expect to receive from the employment of N men, and N, and shows the sum of consumption and investment demand. Given the value of investment demand, which depends on the inducement to invest (which in turn depends on the marginal efciency of capital and on interest rates), the aggregate demand curve is upward-rising because a rise in employment increases income and hence consumption. If D exceeds (is less than) Z, N rises (falls), so that the level of employment is determined by the intersection of the aggregate supply and aggregate demand curves. Although Keynes did not use the AD-AS framework (in the sense that we are using it here, that is, with curves drawn in P -Y space), it is worth noting that Keyness analysis does not suffer from the three alleged problems of the AD-AS framework discussed earlier. On the rst, Keyness analysis assumes competitive (price-taking) prot-maximizing behavior and a variable price level; hence there is no inconsistent use of two theories of pricing and production. On the second, although he does assume that the money wage is xed, this assumption is made only in the rst eighteen chapters of the book. In chapter 19 Keynes points out that a reduction in the money wage may quite possibly depress employment. Arguing that the effect of a wage reduction in reducing the interest rate, and thereby stimulating investment and employment (the Keynes effect), is likely to be weak, Keynes suggests that when wages fall, aggregate demand can be reduced because (1) income redistribution from workers and from entrepreneurs to rentiers reduces the propensity to consume; (2) expectations of further reductions in wages reduce investment; (3) workers may become discontented, which may reverse the optimism found among entrepreneurs due to money wage falls; and (4) falling prices increase the debt burden of entrepreneurs and indeed lead some of them to insolvency with a consequent adverse effect on investment (266). Keynes also adds that a exible-wage economy is not desirable, since it results in price instability, which increases uncertainty in business decision-making (268). Thus wage exibility does not result in full employment. On the third, since Keynes does not visualize curves
14. This must be pieced together from chapter 2 and elsewhere; Keynes does not explain the upward slope of the aggregate supply curve.
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on P -Y space, there is no of conation of microeconomic and macroeconomic concepts. Since Keynes discussed the curves in Z-Nand not P -Y space, it is not surprising that most of those who incorporated Keyness analysis diagrammatically into textbooks in the early days, such as Dudley Dillard (1948), Sidney Weintraub (1951), Alvin Hansen (1953), and A. W. Stonier and D. C. Hague (1953), depicted the Keynesian system in that space. However, their diagrams do not play a major role in any of their texts, and their usually unclear discussion adds little to Keynes (see King 1994). Indeed, several of these texts quickly switch to other geometric treatments of the Keynesian system, as we shall see below. As J. E. King (1994, 14) notes, the subsequent controversy regarding this version of the aggregate supply curve in the mid-fties in the Economic Journal did little to reduce the confusion surrounding the diagram. In subsequent years the diagram caught the fancy of American post-Keynesians like Weintraub (1958), Paul Davidson (1972), and Paul Wells (1977), who provided clearer expositions of the model. However, this analysis seems to have now disappeared from textbooks and even from most of the work of the post-Keynesian school, with a few exceptions (see King 1994, 27 28).15 Of the geometric depictions of the Keynesian system popular today, the rst two to appear were the income-expenditure or diagonal cross model, and what is now called the IS-LM diagram. The income-expenditure model had its debut in Paul Samuelsons 1939 paper on the multiplier-accelerator interaction theory of the business cycle; in that paper Samuelson draws the consumption function in expenditure-income space and determines equilibrium in the goods market at the point of intersection of the C + I line (with investment given autonomously) with the 45 line.16 Although it is conned to a mere two pages in Samuelsons paper, in less than a decade this model became the backbone of Samuelsons 1948 principles text (see Pearce and Hoover 1995). The
15. The discussion of these models, which can be called the aggregate demand price and aggregate supply price models, would take us too far aeld, since the relationship between these models and the AD-AS framework discussed in this paper is unclear and shrouded in controversy. See, however, King 1994 for a history of these aggregate demand price and aggregate supply price models. 16. Patinkin (1982) has argued that this diagrammatic apparatus not only represents the essence of Keyness theory of effective demand, but that it is implicit in The General Theory and that it is verbally developed by Keynes himself in How To Pay for the War (1940). Be that as it may, Samuelsons paper predates Keynes 1940.
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diagram (measuring real or nominal output or income on one axis, and expenditure on the other) also appears in Dillard 1948, Patinkin 1949, and Weintraub 1951. Because of its simplicity, this model with the axes measuring real income and expenditure subsequently became the popular method of presenting the Keynesian theory of aggregate demand and unemployment in textbooks. It is usually presented at the beginning of the analysis of income determination but argued to be a rst simplication with a given interest rate and price level;17 later chapters relax these assumptions by bringing in asset market considerations and the effects of wage and price changes. The IS-LM model appeared in print even before the diagonal cross model in John Hickss 1937 paper, where it is called the SI-LL model. Although there are other contemporary versions of the model by James Meade, Roy Harrod, and others (see Young 1987 and Darity and Young 1995), Hickss model, which was the most inuential (perhaps because it was presented geometrically), is worth examining in some detail because of its close similarity with the AD-AS model presented in equations (1) through (8), a fact that becomes clear by translating Hickss two-sector (producing investment and consumption goods) schema into a one-sector one (see gure 3).18 Following Hicks, we can derive the SI-LL in Z-r space given W as follows (where, as before, Z P Y denotes money income and output). Equations (1) through (3) give a nowfamiliar inverse relation between r and Y . Also, equations (6) through (8) imply that P rises with Y , given W . Since Y rises when r falls, and P rises when Y rises, we obtain an inverse relation between r and Z. This yields the SI curve, which combines the goods market equilibrium condition and the supply-side relations. Next, starting with equilibrium in the money market shown by M = P L(Y, r), which combines equations (4) and (5), an increase in Y implies a rise in L as well as a rise in P from equations (6) and (7), which implies a rise in the nominal demand for money, P L, and hence an excess demand for money. Since r has to be increased to remove this and restore equilibrium, we get a positive relation between r and Z, producing equilibrium in the money market and satisfying the supply-side equations (6) and (7); this yields the LL curve. The intersection of the two curves solves for the equilibrium values of Z
17. Since the price level is taken as given, the model is usually interpreted as one in which rms adjust output according to demand; since price-taking prot maximization is not assumed, there is no inconsistency. 18. See also Barens 1997 for a discussion of Hickss analysis in terms of one sector.
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S L
I Z
Figure 3
Hickss SI-LL model
and r, which completes the SI-LL diagram. Once the equilibrium value of Z is obtained, the equilibrium values of P and Y can be obtained using the rectangular hyperbola Z = P Y and the positive relation between P and Y obtained from equations (6) through (8). Since the model is exactly the same as our AD-AS model presented above, despite their different geometric depictions, the properties of the models are identical.19 But what of the problems? Since Hickss model is not xed-price (but xed-wage), and rms follow standard prot-maximizing behavior as price takers, there is no inconsistency about pricing behavior. A fall in the exogenously given money wage, by implying a lower P for a given Y , shifts the SI curve to the left and the LL curve to the right. The interest rate denitely falls and the effect on Z is uncertain, but equations (1) through (3) conrm that the lower r must imply a higher equilibrium Y . Thus the model does imply that wage exibility leads to full employment, which leaves it open to the second criticism. Finally, since Hicks does not draw curves in P -Y space, there is no confusion of macro and micro concepts. If Hickss version of the model is an AD-AS model in disguise (since
19. Apart from the two-sector formulation, there are some (for our purposes) inessential differences with Hickss model due to the fact that in it (1) consumption and saving depend also on r, (2) government expenditure is omitted, (3) the demand-for-money equation is expressed in money, not real, terms, and (4) the money supply is at some times taken to be a positive function of the interest rate.
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it incorporates all of the equations of the AD-AS model discussed earlier, but is not present in P -Y space), by the time Hansen (1949, 1953) puts the IS-LM model into textbooks, it becomes the modern textbook version in r-Y space without explicit consideration of the supply side of the economy, with an exogenous price level.20 Hansen (1949, 125) points out that a fall in the price will reduce the rate of interest by reducing the nominal demand for money, which will increase investment and real output, anticipating the AD curve. However, he argues that this method of reaching full employment through wage reductions is patently absurd, and in fact he discusses several reasons why a wage reduction may not increase employment, including income distributional shifts and an absence of interest elasticity of investment. Hansen also points out that a rise in aggregate demand and output will tend to increase the money wage and the price level, thereby anticipating the AS side as well (135 36); however, he makes no explicit use of it. We now turn to AD and AS curves drawn in P -Y space. We consider these contributions in some detailat the risk of making the narrative read as if history was just one damned thing after anotherto determine priority, to examine how the present versions emerged, and to determine whether the early presentations suffered from the problems discussed above.21 The earliest depiction of Keynesian macroeconomics in price-output space appears to be in Lorie Tarshiss 1947 textbook. Tarshis derives the standard supply curve of the price-taking, prot-maximizing rm from its marginal cost curve, then aggregates to obtain the industry supply curve, and nally generalizes this to the AS curve (Tarshis 1947, 448 50) drawn in P -Y space. Tarshis explains that this curve takes money wage and technology as given, and that it is relatively at at low levels of output (since the strength of diminishing returns is weak), then upwardrising, and then vertical at full employment, due to the scarcity of labor. Tarshis does not have an explicit AD curve, but he determines the equilibrium level of output by equating it to the demand for goods and services (a demand that depends mainly on consumption and investment demand and that is taken to be independent of the price level); the price
20. Another change was that models also mostly assumed that there is one sector in the economy, departing from Hickss analysis (as pointed out above), which considered two sectors. 21. In some cases in which it is obvious, I will not mention whether a model suffers from each of the three problems. See, however, table 2 for a summary of the major contributions and their problems.
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level is therefore determined by the AS curve and the equilibrium level of output, with the latter implicitly giving the vertical AD curve (452).22 Although Tarshis does invoke the Keynes effect in analyzing the effects of a rise in the money supply (453), he also argues that a fall in the money wage may increase or reduce investment spending, depending on how expectations and industrial relations are affected (although there is a good chance that investment spending will increase if protability is increased and the interest rate falls), and most likely will reduce the propensity to consume due to a redistribution away from labor, so that the combined effect on aggregate demand and hence output is indeterminate (55564). Both AD and AS curves in P -Y space appear rst in Kenneth Bouldings 1948 textbook and O. H. Brownlees 1948 contribution to a textbook on applied economics.23 Boulding does not use the curves to determine the price level and aggregate output, but rather to reveal the dangers of aggregative thinking, arguing that no solution is possible (262) with such aggregate curves. Brownlee, however, attempts to show how such an analysis is possible. Assuming that the interest rate is given, that the demand for money depends on nominal income, and that the money supply is exogenously given, he draws a downward-sloping curve (of the form MV = P Y , where V is the given income velocity of money) in P -Y space to depict money market equilibrium. Assuming a production function with diminishing returns, prot maximization by rms, and a xed money wage, Brownlee uses a four-quadrant diagram to derive a positive relation between real output and the price level, a relation that gives his labor market schedule; with real output measured on the vertical axis, the curve becomes horizontal at full employment. The intersection of the money market equilibrium and labor market schedules (which we can call the AD and AS) determines equilibrium output and the price level.
22. King (1994) interprets Tarshis as having a downward-sloping AD curve, its slope explained by the fact that higher prices reduce demand, especially among lower income groups. In the pages on which King nds this explanation (47577), Tarshis discusses the fall in consumer demand, which makes possible a lower allocation of GNP to the private sector due to a rise in military spending by the government. However, Tarshis does not incorporate this analysis into his AS diagram. 23. The textbook on applied economics is an edited volume that is used in courses on economic principles and problems. It is intended for use in the second of a two-semester sequence of courses; students are assumed to have had an introduction to economics and to economic analysis already; it can thus be called an intermediate text.
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Turning to the problems, Brownlees model is not inconsistent, since it has only one theory of pricing, in which rms are prot-maximizing price takers. On the effects of money wage changes, a fall in the money wage shifts the AS curve to the left (with price measured on the horizontal axis) and leaves the AD curve unchanged, so the price level falls and output and hence employment rise. Thus, the analysis is open to the second criticism. However, Brownlee (1948, 247) notes that a fall in the money wage also reduces workers income and their demand for commodities and the demand for money, so that the AD curve can also shift to the left, so that it is not necessarily true that a fall in the wage increases employment. Despite determining equilibrium using AD and AS curves, Brownlees claim to presenting the rst AD-AS model is compromised by the fact that his AD curve does not explicitly incorporate the goods market. As noted above, this procedure is made possible by assuming that the interest rate is xed. Although Brownlee does not provide a reason for this assumption, it is problematic if it is xed by the monetary authorities who adjust money supply, for then it is no longer permissible to assume that money supply is given, as his presentation does. When Brownlee discusses the case with a variable interest rate, which affects the level of investment, he uses the 45 income-expenditure diagram to show how nominal output is determined by goods market equilibrium, but this analysis is not incorporated into the AD-AS framework. Within two years, however, in a paper published in the Journal of Political Economy, Brownlee (1950) achieves the distinction of being the rst to present a published version of a complete AD-AS in P -Y space. Without referring to any earlier work on the IS-LM model, Brownlee uses goods and money market schedules in Y -r space to determine equilibrium output for a given price level. Since a higher price level shifts the money market schedule upward, equilibrium output falls, so that the downward-sloping AD curvewhich Brownlee calls the ZZ curveis obtained in a quadrant measuring Y on the vertical axis and P on the horizontal. Turning next to the supply side, Brownlee notes that with a perfectly exible money wage, there is a unique level of employment at full employment, given capital and technology, and, correspondingly, a unique level of real output independent of the price level, which is shown by a horizontal Y Y curve. If the money wage is xed, however, the relation between real output and the price level that will fulll the condition of equilibrium in the labor market (implying that employment is
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determined by labor demand, but without labor market clearing) is an upward-rising W line that becomes horizontal when it reaches the Y Y curve (as in his earlier presentation). The intersection of the ZZ and W curves determines the levels of real income and the price. With a given money wage, the equilibrium level of real income or output may well be below the full employment level, and Brownlee terms this the Keynesian solution. Brownlee does not take the price level to be the exogenous variable in the sense of assuming quantity adjustment in the goods market for a given price; rather, the AD curve is explicitly dened as showing combinations of P and Y showing goods and asset market equilibrium. Thus there is no evidence of inconsistency in his presentation and no confusion of micro and macro concepts. If the money wage falls, the W curve shifts to the right, so that equilibrium output and employment rises. But no positive wage that ensures full employment may existif the interest does not affect the aggregate demand for goods or if the interest rate cannot fall. If, however, a price reduction increases the real value of monetary assets, which in turn increases consumption, wage reductions will increase the level of real output even in the cases in which the Keynes effect does not work. Thus, the models logic does imply that wage exibility leads to full employment, despite Brownlees cautionary remarks. Closely on the heels of Brownlee, Jacob Marschaks (1951) published lecture notes provide the rst full textbook treatment of the AD-AS model. In lecture 2 Marschak presents the same model as in Brownlee 1948, although without citing him or anyone else. Subsequent lectures develop the Keynesian income-expenditure analysis in which money output is determined by the consumption function (which makes the level of money consumption depend on the levels of money income and money supply) and the exogenously xed level of money investment. Variations in both physical output and price can equilibrate demand to supply. Extensions of this model make money investment depend positively on money income and the interest rate, and money consumption depend on the interest rate in addition to the variables mentioned earlier. In the money market, nominal money demand is taken to depend on the interest rate and the level of money income, and exogenous money supply is set equal to money demand. Money and goods market equilibrium is then presented in interest rate and money income space with curves that look like IS and LM, although money income (as in Hickss presentation) is measured on the horizontal axis. In this discussion there
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is no xed-price assumption, so there is no inconsistent use of two price theories. Lecture 18 moves to a space with price and real income on the axes in which he derives a downward-sloping curve showing the demand curve for all goods (DD) drawn on a quadrant measuring Y and P on the vertical and horizontal axes. The curve embodies both the interest rate effects on investment and consumption and the real balance effect on consumption. The supply curve for all goods (SS) is drawn using the labor demand condition, which sets the real wage equal to the marginal product of labor; the production function, which relates real output to employment; and a supply curve of labor, which makes the money wage depend positively on the level of employment (reecting what Marschak calls money illusion);24 demand and supply of labor are assumed to be equal in deriving SS. DD and SS are drawn on a diagram measuring real income on the vertical axis and the price level on the horizontal axis, and the two curves intersect to simultaneously determine the two variables (pp. 5657).25 If there is no money illusion (so that the supply of labor demands on the real wage and the labor market clears), the SS curve is horizontal; this is the full employment case. Marschak also presents a case similar to Brownlees (1950) in which the money wage is xed (due to collective bargaining) and there is no labor market clearing. Two other early AD-AS models may be briey mentioned. Weintraubs 1951 textbook uses demand and supply curves in a space in which price and real output are on the two axes to show equilibrium. The supply curve is based on the marginal cost curves of rms as in the contributions just discussed, but the AD curve (called the income-demand curve), drawn for a given level of investment, is downward-sloping without any explanation. Since Weintraub provides no explanation for the negative slope of his macroeconomic AD curve, it is possible that he conates macroeconomic and microeconomic considerations, but if so, it is the only AD curve from this period surveyed here that does so. Bent Hansen (1951), whose treatise aims to develop equations of motion for ination rather than determine equilibrium output at the intersection of AD and AS curves, derives the curves on P /W -Y space. The AS curve is derived in the standard way, given the money wage, using the assumptions of diminishing returns, prot maximization, and perfect competition.
24. The equation is the same as equation (8a) in the present text, interpreted as a supply curve. 25. This is essentially our earlier AD-AS model but with equation (8) replaced by (8a).
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However, Hansen explicitly refers to expectations, stating that the supply curve shows for any given price expectation the level of output that will be produced in the economy. The demand side has two features that distinguish it from the other contributions of the period. First, Hansens curve shows quantity of aggregate demand for goods, not equilibrium in goods and asset markets. Second, aggregate demand falls when P /W rises because of a fall in consumption demand due to a shift in income distribution from workers to capitalists, who have a lower propensity to consume, rather than any effect on real investment, which is assumed to be given by a xed level of the interest rate. AD-AS Analysis in Intermediate Textbooks After its initial appearance, the AD-AS analysis took a few years to make its way into standard textbooks. The story of its appearance and spread in intermediate texts is rather different from that in principles texts; I therefore tell them separately. The intermediate textbook by Joseph McKenna (1955)26 appears to be the rst standard textbook to contain the AD-AS model,27 if we do not include Brownlee 1948 and Marschak 1951 in that category. McKenna follows Marschak in starting with the diagonal cross model (taking the price level and real investment to be given), moving next to the IS-LM model (with a given price level), and then deriving the downward-sloping AD curve by examining the effects of the change in price due to the Keynes effect. The AS curve is derived both for the case of perfect competition (as in earlier presentations) and of monopoly with a constant price elasticity of demand for goods and an informal aggregation procedure, with a given money wage when unemployed labor exists. At full employment, with perfect wage exibility, the curve becomes vertical. McKenna refers to Hicks 1937 for the IS-LM framework and Brownlee 1948 for the AS side of the AD-AS framework. Drawing the curves in a diagram with P and Y on the vertical and horizontal axes, McKenna
26. McKenna does not require students to have any prior knowledge of economics. But since it assumes familiarity with algebra, I classify it as an intermediate-level text. 27. Sinceto the best of my knowledgethis is the rst attempt to write the history of the AD-AS approach in price-output space, I have had to rely on my own review of textbooks. Although I have tried to cast my net as widely as I could, it is possible that some books have escaped my attention. This explains my use of the phrase appears to be quite frequently in the following narrative.
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explains that their intersection determines equilibrium P and Y , at which unemployment may prevail. McKenna nowhere states that the AD curve is derived from quantityadjusting behavior by rms at a given price level. The curve merely shows combinations of P and Y at which goods and assets markets are in equilibrium. Without the xed-price interpretation for the AD curve, there is no necessary inconsistency between the AD and AS sides, although since he does not explicitly say that variations in the price level clear the goods market there may be one. McKenna points out that if the money wage is exible, the wage will fall, shifting AS downward, thereby reducing unemployment. He states that this has led some to argue that Keynesian unemployment is possible if the wage is rigid, but argues that Keyness analysis was not based on wage rigidity since wage exibility may not be effective in increasing employment. Indeed, he states that the liquidity trap will make the AD curve vertical, preventing output increases when the wage falls; but he continues that the Pigou or real balance effect will make it downward-sloping again. Thus although McKenna repeats and apparently endorses Keyness views on wage exibility, his AD-AS model with both Keynes and real balance effects suggests that the economy goes to full employment with exible wages. No other textbook seems to have used the framework until McKennas second edition appeared in 1965. In fact, up to the late 1970s only two other textbooksthose by John Lindauer (1968) and D. C. Rowan (1968)appear to have used it, the rest conning their attention to the income-expenditure and IS-LM models. Lindauer mostly follows McKenna, although he draws on Keynes to additionally discuss a number of reasons why price and wage reductions need not take the economy to full employment. The signicance of this book will become clear in the next section. The signicance of Rowans work lies in its attempt to reformulate the AD-AS model. Although his AS curve is the standard one with perfect competition and a given money wage, his AD curve is different from the earlier one, which, being derived from the IS-LM equilibrium output for different price levels, is a schedule showing goods and assets market equilibrium rather than a real AD curve. Rowan instead takes a given price, nds the corresponding output supply from the AS curve, then nds the levels of consumption and investment demanded at that output level and the corresponding interest rate for asset market equilibrium, and nally adds them together to arrive at aggregate demand. The AD schedule traces out aggregate demand at different
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price levels and shows how much businessmen will sell if they produced their planned output at a given price level (328).28 This curve is upward-rising up to the price level at which full employment is reached (since higher price implies higher levels of output and hence consumption demand), but above that price it becomes backward-bending, since there is higher price but no higher output. In its positively sloped segment it is steeper than the AS curve. Output and price are determined at the intersection of the AD and AS schedules. Rowans model is an early textbook presentation of the Walrasian disequilibrium approach with rationing at a (temporarily) xed price, and like other xed-price disequilibrium models with perfect competition, the model suffers from the inconsistency of having price-taking rms that cannot sell all they wish at the going price.29 The model has the additional problem that it does not make consistent use of the short-side principle in calculating effective demand, taking the level of output supplied notionally, rather than the level of output actually produced (see Dalziel 1993). Rowans later book, Rowan and Mayer 1972, removes the AD-AS apparatus, returning instead to a brief treatment of the AD-AS in Z-N space in addition to the income-expenditure and IS-LM models. Despite the fact that he failed in his endeavor, Rowans attempt to derive the AD curve as a true demand schedule for all goods (like Bent Hansen) rather than an equilibrium schedule for the goods and asset markets, is an interesting one, if only to point out that the AD curve is not a demand curve at all. The two popular new textbooks that appeared in the closing years of the 1970sDornbusch and Fischer 1978 and Gordon 1978and another widely used textbook in its second editionBranson 1979all use the AD-AS framework. After presenting the income-expenditure and IS-LM models with a constant price, they derive the AD curve by
28. In terms of the equations of the model in table 1, Rowans diagram is derived as follows. The AS curve shows the value of Y at each level of P from equations (6) through (7) in the usual way. The curve, however, becomes vertical at the full employment level (given a standard supply curve of labor, which shows labor supplied at each real wage). The AD curve is derived as follows. We start from a given P . From equations (7) and (8) we nd N, which yields the value of Y from equation (6). This output is restricted to not exceed the full employment level, as in the AS curve. The P and Y just found are inserted into equations (4) and (5) to nd the asset market clearing level of r. These values of r and Y are substituted into equations (2) and (3) to nd the levels of C and I . These values, together with the exogenously given level of G, are summed up to get the aggregate demand at the given P . The AD curve is found by nding this level of aggregate demand (C + I + G) for each P . 29. See, for instance, Dutt 1987 for an elaboration of this point.
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determining real output from the model for different price levels, following earlier presentations; Gordon also introduces the real balance effect. They depart from earlier tradition in their treatment of the AS side, however. Dornbusch and Fischer develop the AS curve under the assumption of imperfect competition, with rms charging a markup over wage costs.30 Given a Phillips curve, which shows that a lower unemployment rate implies a higher rate of wage increase, a positive relation between the output level and the price level, given last periods wage, is derived: a higher output level implies a higher employment level, a lower unemployment rate, a higher rate of wage change, a higher wage (given last periods wage), and hence a higher price from the markup equation. This is the short-run AS curve, which extends beyond the potential or full employment output level. Gordon and Branson, on the other hand, consider a Friedman-Phelps supply curve in which workers make labor supply decisions given the expected real wage, rms make labor demand decisions under perfectly competitive assumptions and diminishing returns, given the real wage (since, unlike workers, they are assumed to know the price of the product),31 and the labor market clears through money wage variations. The AS curve is obtained for a given price expectation: starting from an initial position of labor market equilibrium, a higher price level implies that rms demand more labor at a given money wage while workers supply no more (since expected price does not change), there is excess demand for labor, and the money wage and employment levels are higher, so that output is higher.32 Gordon and Branson therefore verbally tell a Keynesian story but use a Friedman-Phelps labor market model with perpetual labor market clearing in which output deviates from the full employment level only due to worker misperceptions regarding the price.33 The
30. Successive editions of Dornbusch and Fischer have changed the nature of the pricing rule. The earlier editions assumed diminishing returns but set the price as a markup on the wage or a constant multiple of the wage (the multiple being determined by the labor-output ratio at expected output). Later editions have assumed a xed-coefcient technology with a constant labor-output ratio, and assumed that the price is a constant markup on unit labor costs. The markup equation has also been modied to take into account nonlabor material costs to examine the effects of oil price shocks. 31. Branson also considers the case of imperfect competition. 32. For a given price expectation of workers, the curve is the same as Marschaks (1951) curve. However, Marschaks model assumes money illusion rather than expectational errors which can lead to the revision of expectationssee below. 33. In a later edition Gordon (1981) also presents a version with unemployment due to a rigid money wage in the short run, as in his earlier presentation. In a still later edition Gordon
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introduction of rational expectations into this model would convert it completely into a new classical model! Output and the price level are determined at the intersection of the AD and the AS in all three presentations, but this equilibrium is a short-run one. Dornbusch and Fischer are the most explicit on this point, analyzing also the longer-run dynamics of the model explicitly. If the levels of output and employment are lower than their potential levels, the money wage will be lower in this period than in the previous period, so that last periods wage will be lower in the next period than in the current period. This implies that the short-run AS curve will move downward. Given that the AD curve is downward-sloping, the economy must converge to a long-run equilibrium at which the short-run AS curve and the AD curve intersect each other at the potential level of output, which is denoted by a vertical long-run AS curve at which the money wage does not change over time.34 Thus we obtain the result that in the short run there may be unemployment (or overemployment), but in long-run equilibrium the economy will be at full employment. This appears to be the rst textbook neoclassical synthesis model that explicitly uses AD and AS curves and that has Keynesian unemployment in the short run (at the intersection of the AD and short-run AS curves) and classical full employment (at the intersection of the AD and long-run AS curves) in the long run (although the idea was present in other presentations that did not use formal AD-AS models, as in Samuelsons principles text from the third edition onward). Gordons AS curve also moves when we go beyond the short run as rms revise their short-run price expectations adaptively. When price expectations are fullled in long-run equilibrium, the AS curve is vertical and the economy is at its potential level of output. Despite this implication of his model, Gordon does not appear very convinced that this self-adjusting mechanism will work, due to a liquidity trap, consumers expecting prices to keep falling when there is deation, and the redistribution of income from debtors with a high propensity to spend to creditors with a lower propensity to spend, ideas that are left out of his formal model. Branson does not explicitly develop a long-run AS curve,
(1984) removes this Friedman-Phelps version of the supply curve and bases it entirely on the assumption of a rigid money wage. 34. The process works in reverse if output exceeds the potential level, with the short-run AS curve shifting upward until the economy arrives at long-run equilibrium at the potential level of output.
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but since his long-run Phillips curve is not vertical, it appears that he does not expect full employment to exist in the long run. Most subsequent intermediate texts adopted some form of the ADAS model. Surveys of intermediate texts show that out of twenty reviewed, only twoAuerbach and Kotlikoff 1995 and Barro 1990do not contain the AD-AS model (Dutt 1997; Grieve 1998).35 The AD-AS models in the texts that do contain them come in four main versions. The most common is the one that bases the AD curve on the IS-LM model by examining equilibrium output levels for different price levels, and the AS curve on nominal wage rigidity, perfect competition, and prot maximization, as in McKenna 1955. However, almost all of them allow the short-run supply curve to have a positive slope for levels of output above its potential or full employment level (that is, the output level shown by the vertical long-run supply curve), and allow the short-run supply curve to shift in the long run, so that in long-run equilibrium the economy is at the potential level of output. Quite a few of these presentationsalthough not allexplicitly assume quantity adjustment at given prices in deriving the AD curve and can therefore be charged with inconsistency (see Dutt 1997). A second versionas in Hall and Taylor 1991 and Mankiw 1992assumes that the short-run aggregate supply curve is horizontal due to short-run nominal price rigidity, but, in the long run, price adjustment and movements in the short-run aggregate supply curve take the economy to the potential level of output. A third versionas in Dornbusch and Fischer (as mentioned above) and Blanchard 1997explicitly introduces imperfect competition using a markup-pricing equation and has an upward-rising short-run supply curve based on the Phillips curve; over time the short-run AS curve moves due to changes in the money wage, and in the long run the economy is at the potential level of output. These second and third versions do not assume price-taking behavior for rms in deriving the AS curve, so that the charge of inconsistency cannot be sustained. A nal formas in Parkin 1984does not allow for involuntary unemployment even in the short run but derives the short-run AS curve, given the price expected by suppliers of labor (as in the earlier models of Gordon and Branson discussed above); in the long run the economy is at the potential level of output. To the extent that these presentations derive the AD curve by
35. Auerbach and Kotlikoff (1995) present most of their analysis using the IS-LM model, while Barro (1990) devotes only one chapterthe lastto Keynesian models and there uses only the IS-LM model, the rest containing new classical models.
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changing the exogenously given price, they may be charged with inconsistency, although one can make the more charitable interpretation that the curve is derived in this way for heuristic purposes and could have been derived with output as the independent variable. The late dispersal of the AD-AS apparatus in intermediate textbooks in the later 1970s onward may be somewhat puzzling since, as we saw earlier, it had already appeared in the literature in the late 1940s and early 1950s and at least one intermediate textbook had adopted it by the mid-1950s. The timing of dispersal arguably has to do with real-world economic issues and theoretical developments within macroeconomics. In terms of real-world issues, the supply shocks of the 1970s and the high ination rates of the 1970s made it inconvenient for textbooks to continue using income-expenditure and IS-LM models, which focused on the demand side and assumed the price level to be given (see Kennedy 1998). This is conrmed by a perusal of the prefaces of textbooks that adopted the framework in the late 1970s. Dornbusch and Fischer (1978, v) state that real-world events have made them go beyond the standard coverage in presenting also the theory of aggregate supply, [and] the vitally important topics of ination and unemployment. Branson (1979) also states that one of the reasons for introducing the model in his second edition was the ination of the 1970s. In terms of theoretical developments, Keynesian economics was by this time under attack from monetarist and new classical economists who focused on the supply side of the economy and in whose analysis the price level played an important role. The AD-AS model allowed a clearer comparison of the Keynesian system and the monetarist and new classical systems in common terms that highlighted both demand and supply sides of the macroeconomy (Kennedy 1998). Branson (1979) explicitly gives this reason in his preface. Also in terms of theory, the AD-AS model can be thought of as the most complete of a sequence of macroeconomic models. The incomeexpenditure model is usually interpreted as taking the interest rate and the price level to be given; the IS-LM model, as relaxing the assumption about the xed interest rate but continuing to assume a given price level; and, nally, the AD-AS model, as endogenizing even the price level. This sequence made it appear that the AD-AS model is the logical culmination of this sequence of models and hence the most complete and general one for analyzing the economy. This reasonwhich incidentally was already apparent in Marschaks (1951) and McKennas (1955) presentationsmay have had some role in the rapid spread of
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the model, once it was already in a number of textbooks. Finally, conformism (more on which later, in the discussion on principles texts) due to competition among intermediate texts arguably had an important role in this propagation. AD-AS Analysis in Principles Textbooks Principles textbooks were slower in adopting the AD-AS framework, and in fact they were slower in adopting Keyness analysis in any form.36 Garver and Hansen 1937, Benham 1938, Fairchild, Furniss, and Buck 1939, and Meyer 1941, which all appeared after The General Theory, do not discuss Keyness theory of output at all and explain the price level in terms of the quantity theory of money with full employment. If at all they are mentioned, plant closings, output reductions, and business cycles are discussed in microeconomic terms. In later editions, Fairchild, Furniss, and Buck in 1948 and Benham in 1955 continued with this approach. Garver and Hansens 1947 edition and Meyers 1948 edition introduce the Keynesian national accounting scheme and allow underemployment equilibrium, but have no Keynesian theory, the latter not even discussing the consumption function and the multiplier. The only real exception in these early days is the Keynes-inspired textbook by Meade (1936), which analyzes the problem of unemployment in terms of aggregate demand and states that reducing unemployment requires increased spending. Meade does not, however, use equations or diagrams to explain how output is determined. It is not until the appearance of the new textbooks by Tarshis (1947), Samuelson (1948), and Boulding (1948) that the Keynesian model of income determination begins to play a central role in principles texts. Samuelsons text, of course, became the introductory textbook of economics, going through eleven editions by 1980.37 Understandably, Samuelsons dominant position allowed him to set the tone for other principles authors, which makes it important to discuss his version of the Keynesian model. Samuelsons exposition is centered around the theory of income determination using an income-expenditure model that as mentioned earlierhe introduced in Samuelson 1939. Although he relates Keyness theory of liquidity preference, he does not integrate it
36. See also Pearce and Hoover 1995. 37. See Elzinga 1992 and Pearce and Hoover 1995.
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with his model of income determination, presumably since in his view monetary policy is ineffective (see Pearce and Hoover 1995, 197) because of the existence of excess reserves, which allow nancial institutions to absorb the effect of policy changes without changing interest rates. Later editions give a more prominent role to money, but continue with the emphasis on the income-expenditure model. Except in discussions of the inationary gap, the price level and wage determination are also not incorporated into the formal apparatus, but described independently of it. This may be explained at least in part by Samuelsons belief that the Phillips curve is unstable (see Pearce and Hoover 1995, 206). Subsequent textbook writers, such as George Bach (1954), John Guthrie (1957), and Campbell McConnell (1960), follow Samuelson in focusing on the income-expenditure analysis, generally calling the aggregate expenditure curve the aggregate demand curve, and the 45 line (sometimes up to the full employment line, at which it becomes vertical) as the aggregate supply curve. These texts generally assume that the price level is given, but sometimes note that as output increased to the full employment level (before full employment is reached), the price level increased due to increases in the price of materials, wages, or sectoral bottlenecks. The rst principles texts to use the AD-AS analysis appear to be Lindauer 1977 and Baumol and Blinder 1979. As noted earlier, Lindauer had introduced it into his intermediate text almost a decade earlier, where he had derived the AD curve from the IS-LM model and the AS curve with wage rigidity. The principles text, however, provides a supercial treatment, drawing the AD curve with a downward slope without a proper explanation beyond noting that at a lower price customers buy more (596), and the AS curve is drawn with a rising part that is not clearly explained and a vertical part at full employment. Lindauer is clearly choosing an incorrect but simple story over the correct but complicated one of his intermediate text. Upward shifts in AD and AS curves are used to explain ination of the demand-pull and cost-push types, respectively, but the income-expenditure model remains the mainstay of the book. Baumol and Blinder provide a fuller discussion. Although the initial discussion of the AD curve sounds too much like that for a micro demand curvethat is, a higher price, given income, implies a lower quantity demanded the later discussion makes it clear that the downward slope is due to the Keynes effect. The AS curve is explained as having three regions: the rst fairly at, the second rising, and the last virtually vertical. The rst
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is argued to represent the Keynesian approach and the last the monetarist one. Changes in the money wage are argued to shift the AS curve: with unemployment, the money wage falls, shifting the AS curve downward and expanding output, given the downward-sloping AD curve. The authors note that this self-correcting mechanism takes the economy to full employment in the long run, but they point out that shifts in the curve are much more efcient at eliminating inationary gaps than unemployment. The late arrival of the AD-AS curves into principles texts can partly be explained by the fact that these curves, especially the AD, are difcult to explain to students who are just being introduced to economics using simple verbal exposition. Intermediate texts using the IS-LM framework could easily explain the downward-sloping AD curve in terms of shifts in the LM curve and the Keynes effect, and the real balance effect could also be easily introduced through shifts in the IS curve. But principles texts, which almost all used only the income-expenditure diagram, found this harder to do, which is probably why Lindauer eschews such a discussion despite the fact that his intermediate text contains such an analysis. Another reason can be traced to the nature of the economics principles textbook market. The market was dominated for a long time by Samuelsons book, which went through many editions over the years. Samuelson, and others who were popular and who therefore published several editions, arguably found it inconvenient and time-consuming to restructure their texts to incorporate the newly developed AD-AS model. This inertia among the market leaders, who set the tone for other books, probably slowed down the adoption of the model. It is not surprising, then, that when the AD-AS model did end up in texts it did so in new books (as in the case of Baumol and Blinder 1979) or when substantial revisions took place with the addition of new coauthors in the case of established texts. Samuelsons text switched to using the AD-AS only when a coauthor was added in the twelfth edition of the book (Samuelson and Nordhaus 1985). McConnells popular text, which went through numerous editions since it rst appeared in 1960, also went through its most extensive revision (which also involved the AD-AS model) in its eleventh edition, which added a coauthor (McConnell and Brue 1990). An additional feature of the market was the strong need to conform. Even Baumol and Blinder (1979, vi), one of the rst to introduce the AD-AS model in principles texts, write in their preface that they have by and large tried to avoid novelty, and they rst introduce the model almost through the backdoor as a digression (but subsequently go on to
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use it extensively later in the book). These characteristics are probably also present in the intermediate text market (note that the DornbuschFischer and Gordon texts were new ones), but arguably not as important in them because of the smaller size of the market and the absence of a dominant text comparable to Samuelsons. Nevertheless, the need to introduce the analysis was quite strong, for some of the same reasons why the analysis became popular in the intermediate textbooks, mainly, the need to explain the supply shocks and high ination rates of the 1970s. A look at the prefaces of the pioneering books conrms this. Although Lindauer (1977) provides no explanations, Baumol and Blinder (1979, vi) state that while many textbooks initially treat the price level to be given, they from the very beginning analyze the world as it really is, with prices all too readily driven upwards. It is worth noting that Blinder (1979) also used the diagram as the theoretical underpinning to explain the stagation of the 1970s at a relatively nontechnical level. Samuelson and Nordhaus (1985) also use the need to explain the concurrence of unemployment and ination as their reason for adopting the model. But their preface provides an additional reason, that is, to integrate different schools of thought, including Keynesian, classical, monetarist, supply side, rational expectations and modern mainstream macroeconomics (viii). McConnell and Brue (1990) also give the need to explain differences between competing perspectives as one of the reasons for using the model. In the following years other principles texts began to adopt the framework. By 1985, Hansen, McCormick, and Rives (1985) show that out of twenty principles texts they survey, fourteen had the AD-AS framework and another one included it in a supplement to the textimplying a sample adoption rate of 75 percent. While ination continued to make the analysis relevant, two other reasons may be given to explain this rapid spread. The rst is that principles texts began to treat the AD-AS framework as just another application of the standard demand-supply analysis. The typical textbook would introduce that analysis early in the textbook and then use it in both the macro and micro parts of the book, irrespective of which was dealt with rst. As we have already seen, this created some problems in distinguishing the micro demand curve from the macro one, but most textbooks started distinguishing the two curves more carefully, pointing out that the macro curves negative slope was due to the Keynes, real balance, or some other effect. The second has to do with intense competition in the principles text market: the appearance
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of a large number of textbooks vying for a larger share in the large market made each one try to do at least as much as its competitors and more. Since a few adopted the AD-AS model, others were induced to do the same. Conformism, which delayed the appearance of the model in principles texts, now speeded up its diffusion. Even Samuelsons textbook, with coauthor William Nordhaus, eventually bowed to the trend: every chapter in the macroeconomics part of the book is explicitly related to the AD-AS model! Virtually every principles text now contains the AD-AS model, although those texts usually also contain the old workhorse income-expenditure model. Of the eighteen such texts that are currently in existence or had several editions by the 1980s that I reviewed,38 only Heilbroner and Galbraith 1987 and Fusfeld 1988 did not contain the model, implying an increase in the adoption rate of close to 90 percent (in the sample).39 The texts containing the AD-AS analysis have the following common features. First, the AD is shown to be downward-sloping. All of them explain this in terms of the Keynes effect and the real balance effect, most also introduce the foreign trade effect due to substitution between domestic and foreign goods, and a few introduce tax effects and intertemporal price effects (see McCormick and Rives 1998). The downward-sloping AD curve is not normally explicitly derived from the IS-LM diagram. Few textbooks discuss that model, and the handful that do, do so informally, usually in a chapter appendix. There is thus little evidence of inconsistency in terms of pricing theories; the presentations are not specic enough for that. Second, despite this vagueness and reference to the similar shapes of microeconomic demand curves and the AD curve, most recent texts are careful to point out the logic of the AD curve as an equilibrium schedule. Some, such as Parkin 1998, however, leave room open for confusion by dening the curve to show the
38. The books reviewed were Amacher and Ulbrich 1995, Baumol and Blinder 1997, Bronfenbrenner, Sichel, and Gardner 1984, Case and Fair 1996, Colander 1998, Fischer, Dornbusch, and Schmalensee 1988, Fusfeld 1988, Heilbroner and Galbraith 1987, Lipsey, Steiner, and Purvis 1984, Mankiw 1997, Manseld 1992, McConnell and Brue 1996, Miller 1997, Parkin 1993, Rufn and Gregory 1997, Samuelson and Nordhaus 1995, Stiglitz 1997, and Tresch 1994. 39. The rst of these is the eighth edition of the Heilbroner-Galbraith text, which is at a more elementary level than the other texts and contains only the income-expenditure model and a discussion of ination in terms of the Phillips curve. Fusfelds is somewhat idiosyncratic, using explicit Marxian terminology and being the only relatively recent text using Keyness concepts of aggregate demand and supply price (although in Z-Y rather than the earlier Z-N space).
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relationship between the quantity demanded and price (and by presenting the curve before discussing goods market equilibrium in the incomeexpenditure diagram; see p. 521). One textbookColander 1998tries to deal with this problem with a lengthy discussion distinguishing between demand and supply curves and the macro curves used in the textbooks, and by renaming the AD curve the aggregate equilibrium demand (AED) curve and the AS curve the aggregate supply path (ASP). However, in a more recent edition, Colander (2001) returns to the AD-AS terminology.40 Third, the short-run AS curve is drawn to be upward-rising, although most textbooks argue that it is nearly horizontal at low levels of output, then rising, and then vertical at some point beyond the full employment level. The upward slope is explained in terms of (1) some input prices (such as the wage) being relatively xed in the short run, so that rms facing higher prices produce more; (2) increases in some costs (including wages) as output rises, which get translated into higher prices; and (3) the appearance of supply bottlenecks in some sectors as output increases, which pushes up the prices of certain goods. None of the texts, not even Parkins (1993)unlike his intermediate textuses the price misperceptions story. The discussion is not formal, and only one textbook derives it explicitly from prot-maximizing, price-taking behavior for a given wage. Third, all texts make the AS curve shift due to wage changes and argue that the short-run AS curve shifts to intersect the AD curve at the full employment level of output and the vertical long-run AS curve in the long run. Competition seems to have led to not only the adoption of the framework, but also to near complete convergence in its presentation! Conclusion I conclude by summarizing the analysis of the foregoing sections to discuss in turn the appearance and spread of the AD-AS framework, its different forms, and its criticisms, and by commenting on the recent calls for abandoning it. A tabular summary of the main contributions is also provided in table 2.41
40. Colander (2001, ixx) writes in his preface that his alternative methodology involved simply too much analytics for students to learn. 41. The table follows the text in dening the AD-AS framework as one that shows macroeconomic equilibrium using aggregate demand and supply curves in P -Y space. The table does not discuss the problem of dirty pedagogy, which is to be found only in some of the principles textssuch as Lindauers (1977) and several of the later ones.
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Table 2 Summary of Main Economics Textbooks

Author, Date, Type of Work Keynes 1936; scholarly book Effect of Wage Inconsistency? Reduction No Ambiguous
AD curve No. Keynes effect present, but possibly offset by other effects. No. But equations present. Keynes effect.
AS curve No. Analysis based on perfect competition and xed W. No. But equations present, based on perfect competition and xed W. Upward-rising; based on perfect competition and xed W. Upward-rising; based on perfect competition and xed W. Upward-rising; based on perfect competition and xed W.
Hicks 1937; scholarly journal article
No
Rise in output and employment
Tarshis 1947; textbook
No. Implicitly vertical.
No
Ambiguous
Brownlee 1948; article in textbook Brownlee 1950; scholarly journal article
Money market equilibrium with xed r
No
Ambiguous
Downwardsloping due to Keynes and real balance effects. Derived from ISLM. Downwardsloping due to Keynes and real balance effects. Derived from ISLM.
No
Rise in output and employment, although barriers are noted. Not discussed, but implicitly an increase in output and employment.
Marschak 1951; textbook
Upward-rising; based on perfect competition and money illusion in labor supply function or xed W. Upward-rising; based on perfect competition and xed W.
No
Weintraub 1951; textbook
Downwardsloping; not explained.
No
Not discussed
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Table 2 continued
Author, Date, Type of Work B. Hansen 1951; scholarly book Effect of Wage Inconsistency? Reduction No Not discussed; presumably negative due to shift in income distribution. Formal model implies increase in output. But discusses problems.
AD curve Downwardsloping demand schedule due to differential consumption propensities.
AS curve Upward-rising; based on perfect competition and xed W.
McKenna 1955; intermediate text
Downwardsloping; derived from IS-LM; Keynes and real balance effects.
First at, then upward-rising; based on monopoly and then perfect competition with xed and variable W. Upward-rising; based on perfect competition and xed W.
Maybe
Lindauer 1968; intermediate text
Downwardsloping; derived from IS-LM; Keynes and real balance effects.
Maybe
Formal model shows increase in output. Cites Keynes to point out ambiguities. Not discussed
Rowan 1968; intermediate text
Partly upward rising and partly downward sloping; uses AS curve in drawing curve to nd aggregate demand for goods at each price level; not an equilibrium schedule.
Upward-rising; based on perfect competition and xed W.
Yes
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Table 2 continued
Author, Date, Type of Work Dornbusch and Fischer 1978; intermediate text Effect of Wage Inconsistency? Reduction No Increase in output with full employment in long-run equilibrium Same as above; informally argues that this is unlikely in reality.
AD curve Downwardsloping; derived from IS-LM; Keynes effect.
AS curve Short-run rising with markup pricing and Phillips curve; long-run vertical.
Gordon 1978; intermediate text
Downwardsloping; derived from IS-LM; Keynes effect and real balance effects.
Friedman-Phelps Maybe expectation errors; drawn with given price expectations for workers and labor market clearing. Same as Gordon 1978. Maybe
Branson 1979; intermediate text Lindauer 1977; principles text
Downwardsloping; derived from IS-LM; Keynes effect. At lower prices consumers buy more; conating micro and macro concepts. Unclear at rst, then downwardsloping due to real balance and Keynes effects.
Not discussed
Partially upward Not explicit Not discussed rising, but enough to explanation reveal unclear. inconsistency.
Baumol and Blinder 1979; principles text
Has upwardrising part because of wage rigidity.
Same as Lindauer 1977.
Rise in output and employment. Process not very effective. Rise in output and employment
Samuelson and Nordhaus 1985; principles text
Downwardsloping due to real balance and Keynes effects.
Has upwardSame as rising part due to Lindauer the rigidity of 1977. some prices and wages.
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1. The AD-AS framework initially appeared as a formalization of the Keynesian system of output and price determination. However, it was preceded by a number of alternative formalizations, including the diagonal-cross income-expenditure model, the IS-LM model, and the aggregate demand priceaggregate supply price model in employment and value of output space. Hickss original IS-LM model (which he called SI-LL) is virtually the same in structure as the AD-AS model, but it was shunted in a different direction by his popularizers. 2. From its rst appearance in full form in a journal article by Brownlee in 1950 and in the published lecture notes of Marschak in 1951, the AD-AS framework has come a long way: it is now to be found in virtually every textbook at the principles and intermediate levels. It was adopted by McKenna in an intermediate text in the mid-1950s, but did not spread beyond a couple of such texts until the late 1970s, when it was used by a number of leading texts. It was only then that its rapid dispersal started. Its adoption in principles texts began even later, only in the late 1970s, but it was widely adopted in the 1980s and even more so in the 1990s. Today, although textbooks still use the income-expenditure model and the IS-LM model (the latter appearing mostly in intermediate texts), the AD-AS model receives the pride of place as the complete depiction of output and price determination. 3. Although the framework has been known since the early 1950s and appeared in a few intermediate textbooks after that, it spread extensively in the later 1970s only after inationary pressures led economists to give increasing attention to the price level and the supply side, and with the growing challenge of monetarist and new classical alternatives to the Keynesian approach. The adoption by principles texts was delayed by the perceived complexity of the framework, but simplications of the framework (and its identication with microeconomic supply and demand curves), real-world and theoretical developments in economics, and intense competition among different textbooks led to its subsequent rapid spread. The story for the delayed appearance and later rapid proliferation of the framework provides an interesting case study of the spread of ideas in textbooks and of how this spread is affected by real-world events, theoretical developments in the discipline, and conformism. 4. Our history shows that the AD-AS framework has taken many forms. It was initially developed to portray the Keynesian system with a xed wage and perfect competition, but variants also dealt with money illusion, some wage exibility, and imperfect competition remaining
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within the Keynesian system. Some writers also represented full employment equilibrium with perfect wage exibility with it to compare it with the Keynesian case. Subsequent versions of the framework have even dealt with the monetarist price misperceptions story with full employment. While most versions have interpreted the AD curve to show goods and asset market equilibrium and explained its slope in terms of the Keynes effect and the real balance effect, some have interpreted it as a demand schedule for goods or explained its slope in terms of income distributional shifts. At present, however, this diversity has been diminished by an amazing degree of convergence in interpretation, especially in principles texts. 5. The charge of inconsistency between the AD and AS curves cannot be sustained as far as the early developers of AD-AS analysis are concerned. Brownlee, for instance, did not take the price level to be the exogenous variable in the sense of assuming quantity adjustment in the goods market for a given price, but explicitly dened the AD curve as showing combinations of P and Y showing goods and asset market equilibrium. Marschak did not assume a xed price in his treatment of either the income-expenditure or the IS-LM model. Even Hickss SI-LL model is not inconsistent. In subsequent intermediate texts, the inconsistency between the AS and AD sides can be argued to be present only in those texts that explicitly develop the AD curve from the xed-price income-expenditure or IS-LM model and the AS curve from the pricetaking, prot-maximization model; inconsistency is not present in those texts that explicitly assume imperfect competition or those that assume a given price in the short run. Moreover, even those texts that do use the xed-price model to motivate the AD curve and use the perfectly competitive underpinning for the AS curve may not be really inconsistent, since the AD curve can be interpreted as showing equilibrium combinations of price and output that equilibrate goods and asset marketsnot necessarily showing the equilibrium output for a given price (see Dutt 1997 and Kennedy 1998). Since most principles texts do not explicitly discuss the derivation of the AD curve in terms of xed-price IS-LM models, and do not explicitly introduce price-taking behavior in deriving the AS curves, it is difcult to argue that the presentations suffer from internal inconsistency; the vagueness of their discussions protects them from such a charge. In sum, the charge of internal inconsistency may have some merit for some current intermediate texts, and perhaps the
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fault may originate in the early treatments of McKenna and Lindauer, but it cannot be sustained for all texts. 6. As we have seen, almost all textbook presentations of the AD-AS framework today have the implication that unemployment (or in the case of the monetarist model, deviations from the potential level of output) is temporary and self-defeating due to wage variations (or expectational changes in the monetarist model),42 in contradiction to Keyness ideas. Although faithfulness to Keyness ideas should not be taken to be an acid test for the validity of a model, it is quite possibleas discussed earlierthat the result ignores a number of important characteristics of real economies and hence makes the model unsuitable for understanding their behavior. Three comments should be made about this criticism, however. First, as our history has shown, the early contributors to AD-AS analysis such as Tarshis and Brownlee explicitly pointed out that a wage reduction need not increase employment. Early presenters of the framework in textbooks such as McKennas and, especially, Lindauers, and in some later texts such as Gordons, also make it clear that Keyness view was that wage reductions need not take the economy to full employment (although the formal models developed by all of them do imply full employment in the long run due to the Keynes and real balance effects). The neoclassical synthesis model with long-run full employment appears explicitly only in the late 1970s. Second, the wage rigidity view of Keynes, which states that without such rigidity the economy goes to full employment and the economy is therefore self-correcting, is a view that has spread widely and is now accepted by mostbut by no means allmainstream Keynesians, especially the new Keynesians (see Dutt and Amadeo 1990a). However, the propagation of this view is a phenomenon that is to a large extent independent of the development of the AD-AS framework, although it is arguable that the framework may have aided it. Hickss early SI-LL model and subsequent IS-LM models imply the result. Franco Modigliani (1944) analyzed a Keynesian model in which the money wage is rigid below full employment and argued that the distinctive feature of Keyness analysisa feature that enabled him to get unemployment at equilibriumis the xed money wage assumption. Modigliani admitted that if the liquidity trap existed,
42. For the monetarist price misperceptions model, this should be translated to read that deviations from the potential level of output are temporary and self-defeating due to expectational changes.
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unemployment could exist without a rigid money wage (he could too have added that this could happen also if investment is interest inelastic); otherwise a reduction in the money wage will reduce the price and, through the Keynes effect, expand output and employment. A. C. Pigou (1943), Gottfried Haberler (1946), and Don Patinkin (1956) went further to point out that money wage rigidity was essential for Keyness conclusion of unemployment equilibriumeven if the interest elasticity of investment was zero and the economy was in the liquidity trapbecause of the real balance effect, a point that was also made in Brownlee 1950.43 Third, since the result depends on having a negatively sloped AD curve that does not shift when the money wage is changed, it is possible to avoid it by taking the curve to be upward-rising and by assuming that it moves to the left when the money wage falls, thereby taking into account some of the arguments and the other critics of the AD-AS framework (see Dutt 198687). Thus, the negative slope for the AD curve assumed in almost all presentations does not invalidate the AD-AS apparatus. 7. The problem of vagueness and dirty pedagogy arguably affected the early principles texts that appeared in the late 1970s, but not the intermediate texts, which were quite explicit in their treatment of the AD curve. Even principles writerswho all too often slip into the practice of dening the AD curve as showing the aggregate quantity of goods and services demanded at each pricehave subsequently become more careful about the problem and provide clearer expositions of the curve as an equilibrium schedule.44 The problem is therefore not insurmountable. 8. The foregoing discussion allows us to conclude that the history of AD-AS analysis does not provide us with a case for jettisoning the framework. The criticisms of internal inconsistency, lack of realism, and dirty pedagogy may apply to some versions of the analysis, but not to many, and the problems have in some cases arisen recently. In any case, they do not imply insurmountable obstacles. But the failure of these criticisms to stick may not be enough to convince us that the AD-AS framework should be retained. The history of AD-AS has shown us that the spread of the framework was related to
43. Meir Kohn (1981) has argued that even without the real balance effect, money wage rigidity is necessary for unemployment equilibrium, since investment depends on the real interest rate, which is not xed by the liquidity trap. 44. Indeed, Colander, one of the early critics of dirty pedagogy, writes in the preface of the latest edition of his principles text that all principles books now do a better job presenting the AD/AS model, and distinguishing it from a micro supply/demand model (Colander 2001, x).
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the rise in importance of price level changes and inationary pressures in the economy and to the rise of alternative models that stress the supply side of the economy. We may be led to argue that ination is no longer an important issue in present-day economies and the world may in fact reveal deationary tendencies. However, in addition to the fact that the claim that ination has been tamed may be premature, the need for the analysis of both the price level and output arises because stable prices are worthy of explanation, and the effects of deationary tendencies need to be understood, for which the AD-AS framework continues to be a useful tool. Moreover, macroeconomists also do not agree on a single model of the economy, as evidenced by the presence of a variety of models in textbooks and in the scholarly literature. By virtue of its exibility in portraying a number of different models of the economy in price-output space, the AD-AS framework can be used to understand these different models and to compare them using a common framework. Indeed our history of the framework has shown that different forms of the framework exist in the literature, and many textbook writers have used the framework because of its ability to compare alternative approaches and models in macroeconomics. These different models include not only standard monetarist/new classical and new Keynesian models, but also those that incorporate imperfect competition, income distributional issues, and the adverse effects of wage reductions stressed by post-Keynesian economists and other more mainstream Keynesians. It is in this that the main strength of the framework lies, making it a more useful device for teaching macroeconomics than alternative presentations such as the incomeexpenditure and IS-LM models, which do not explicitly incorporate the aggregate supply side. References
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Aggregate Supply Aggregate Demand Analysis A History

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Aggregate Demand-Aggregate Supply Analysis: A History

Dutt, Amitava Krishna.

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Aggregate DemandAggregate Supply Analysis: A History

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

Table 1 Equations of the Basic Model

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Hickss SI-LL model

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

History of Political Economy 34:2 (2002)

Dutt / AD-AS Analysis

Table 2 Summary of Main Economics Textbooks

Hicks 1937; scholarly journal article

Rise in output and employment

Tarshis 1947; textbook

No. Implicitly vertical.

Brownlee 1948; article in textbook Brownlee 1950; scholarly journal article

Money market equilibrium with xed r

Marschak 1951; textbook

Weintraub 1951; textbook

Downwardsloping; not explained.

History of Political Economy 34:2 (2002)

AD curve Downwardsloping demand schedule due to differential consumption propensities.

AS curve Upward-rising; based on perfect competition and xed W.

McKenna 1955; intermediate text

Downwardsloping; derived from IS-LM; Keynes and real balance effects.

Lindauer 1968; intermediate text

Downwardsloping; derived from IS-LM; Keynes and real balance effects.

Rowan 1968; intermediate text

Upward-rising; based on perfect competition and xed W.

Dutt / AD-AS Analysis

AD curve Downwardsloping; derived from IS-LM; Keynes effect.

Gordon 1978; intermediate text

Branson 1979; intermediate text Lindauer 1977; principles text

Baumol and Blinder 1979; principles text

Has upwardrising part because of wage rigidity.