2.1.7   AS/AD Analysis

Neoclassical AS/AD Analysis

AS/AD analysis with a neoclassical economics has one key difference with Keynesian AS/AD. It assumes that labour markets will respond to price changes. In other words, there are no ‘sticky prices.’ As we will see, this gives justification to letting the market sort things out without government intervention.

Increase in AD Using Neoclassical Model

We start with the following diagram:

This diagram shows that the market is in initial equilibrium, with Real GDP at Y1 and Price Level at PL1.

We may upset this equilibrium by increasing Aggregate Demand. This may happen due to rising consumer confidence, lower interest rates, more government spending, or a depreciation in the exchange rate. In other words, a rise in any component of AD (AD = C + I + G + (X-M)):

We have a new equilibrium at Y2PL2. As a result of the higher AD, Price Level has risen from PL1 to PL2 and Real GDP has grown from Y1 to Y2.

The important thing to note here is that Y2 is above Y1, which is our LRAS. In other words, we are producing at a level that is beyond the long-run capacity of the economy; we have a positive output gap.

How can we do this? This seems to imply that we are producing beyond our PPF, which seems to be a contradiction.

The reason is because this is a short-run increase in production only. Imagine you are on a long run, say 10 miles. You will have a long-term steady pace that you can maintain for this distance, which will be slower than your short-term sprint pace. If a dog suddenly jumped out at you in the middle of your run, you would be able to run faster for a short period of time, but you wouldn’t be able to maintain the fast pace forever. That’s what we man by this: we are producing in the short-run at a higher level than our long-run capacity.

We can attain this higher level of production in the short-run through doing the following:

• Paying our workers overtime, i.e. asking them to come in on their days off or working later than their shifts.
• ‘Sweating’ our machines (a real economic term), i.e. running our capital equipment non-stop and not providing the maintenance breaks that we know we should.

Operating at this level is, by definition, not sustainable in the long-run. Eventually our workers will get tired of asking to be in all hours. They will begin to ask that their overtime pay be reflected in their normal contracts. Eventually, our capital will break down if we are sweating it too much and not giving it proper maintenance. The replacement of this capital will push up our capital costs.

The higher wages and increased capital costs are nominal changes to our model; they will cause a shift in the SRAS. Because these operating costs are now higher, for any given price level we will now have a lower SRAS. In other words, the SRAS shifts to the left:

This leftwards shift in SRAS means that we have reached a new equilibrium at Y3PL3. Real GDP has reverted back to our LRAS level. And the resulting increase in labour and capital cost has pushed up Price Levels even further, from PL2 to PL3.

Important link back to the assumptions of SRAS: remember that the short-run is defined as the period in time in which nominal wage rates are fixed. So when we saw an increase in AD (before we could adjust nominal wages) we were stuck on SRAS1. The higher AD, with nominal wages unchanged, allowed us to produce beyond the long-run productive capacity of the economy. When we allowed nominal wages to change (as a result of overtime and sweating machines), we entered a new short-run time period and we changed to SRAS2. With wages adjusted, we could no longer afford to produce beyond our long-run capacity.

End result: as a result of higher AD, we now have higher Price Levels (inflation) but no real increase in our economic growth. The market has self-stabilised, meaning it sorted itself out without any government intervention.

This would lead neoclassical economists to conclude:

• Be careful when stimulating AD; it will only be inflationary in the long-run.
• If you want long-run growth, you need to change LRAS (e.g. through supply-side policies; which is why many neoclassical economists are also considered supply-side economists)

Decrease in AD Using Neoclassical Model

We use the same line of analysis to explain the effects of a decrease in AD using this model.

Again, we start with an economy in equilibrium:

This diagram shows that the market is in initial equilibrium, with Real GDP at Y1 and Price Level at PL1.

We may upset this equilibrium by decreasing Aggregate Demand. This may happen due to falling consumer confidence, higher interest rates, less government spending (austerity), or an appreciation in the exchange rate. In other words, a fall in any component of AD (AD = C + I + G + (X-M)):

We have a new equilibrium at Y2PL2. As a result of the lower AD, Price Level has fallen from PL1 to PL2 and Real GDP has fallen from Y1 to Y2.

Y2 is now below Y1, which is our LRAS. In other words, we are producing at a level that is lower than the long-run capacity of the economy; we have a negative output gap. The difference between Y1 and Y2 represents unemployment in the economy.

Keynesians and neoclassical economists would agree that the lack of AD has led to lower Real GDP and lower Price Levels. Firms will be keen to sell the stock of goods that they already have, and with lower AD the firms will lower their price levels in order to shift them. The lower AD will be a signal to the firms that they shouldn’t produce as much, so output (Real GDP) decreases.

The key difference in assumptions between Keynesians and neoclassicals is what happens after this. Keynesians assume that there are sticky wages: that workers will have the power to prevent the firms from giving them nominal wage cuts, even when there is a lack of AD and plenty of workers unemployed willing to take their jobs. This is the reason why Keynesians assume that AS has a long elastic section: a place where unemployment may persist, even with a lack of AD.

The diagram below shows a Keynesian AS curve imposed on our AS/AD analysis. Following the fall in AD, Keynesians would believe that we may stay at Y2 for a long period of time:

Neoclassicals argue that wages aren’t quite so sticky as the Keynesians might assume. The negative output gap and high unemployment will, according to the neoclassical economists, put downward pressure on nominal wages.

The lower nominal wages are nominal changes to our model; they will cause a shift in the SRAS. Because operating costs are now lower, for any given price level we will now have a higher SRAS. In other words, the SRAS shifts to the right:

This rightwards shift in SRAS means that we have reached a new equilibrium at Y3PL3. Real GDP has increased back to our LRAS level. And the resulting decrease in labour costs have lowered Price Levels, from PL2 to PL3.

The result is that following a fall in AD, we have seen the labour market adjust to compensate. Lower AD meant higher unemployment, but the unemployment allowed firms to renegotiate lower wages for their workers. By having lower labour costs the firms were able to hire back the unemployed workers and bring back production to its original level, and the lower labour costs have led to lower price levels as a result. Again, the market has self-stabilised, meaning it sorted itself out without any government intervention.

Conclusions:

• There is no need to take government any action, even in a recession. The market will sort itself out.

Evaluation

So which approach is correct? How should we use these models to inform policy?

The first point to observe that any question of disagreement between these two models is largely one of time frame. Neoclassical economists believe that the market will sort itself out, eventually. But how long should policymakers be willing to wait until this happens? Everything will be fine in the long run, according to neoclassical economists, but Keynes had a famous retort to this: “In the long run, we are all dead.” Keynesian economics seems to make greater allowance for the fact that markets are not perfect, and in the immediate time frame there will be people who will suffer while we wait for the economy to return to equilibrium. This thinking would suggest that governments should save their citizens the pain of long-term unemployment by nudging the economy back to full employment a bit sooner than normal.

The second point is that it all comes down to how ‘perfect’ you believe your labour market to be. It’s easy to theorise that markets will adjust wages to high unemployment, but nobody can deny that the existence of labour unions will have some effect on protecting the nominal wages of workers. But one can observe how the labour market has changed in the past 20 years to be more flexible. For example:

• Labour unions have decreased in power since the 1980s.
• Remote and flexible working has given firms a wider pool of workers.
• The ‘gig economy’ of workers working for Uber, Deliveroo, etc. has less negotiating power than workers in traditional companies.

So a good way of evaluating each approach would be to look at real-life evidence of how flexible labour markets have become (there is a strong link between this idea and the Phillips Curve topic).

The debate about which approach is better has continued since Keynes originally published his work in macroeconomics in the 1930s. Governments at the time took his advice, and through massive spending programmes (and through paying for World War 2) the economy recovered from the Great Depression of the 1930s.

By the 1970s, however, there appeared to be holes in the Keynesian theory when persistent inflation began to appear in the economy. Policy makers began to listen to the ideas of more neoclassical economists, such as Milton Friedman and Friedrich Hayek, to fight the threat of high inflation. This new neoclassical worldview was dominant through the 1980s, 90s, and 00s until the financial crisis of 2008, when it seemed that the principles of ‘let the market sort itself out’ had failed to deliver stability and prosperity.

Since 2008 and the massive government spending that occurred in response, it seems that Keynesian thinking is now back in fashion. This is certainly the case following the covid-19 pandemic, where governments across the world have spent trillions of pounds to support workers in the face of low aggregate demand. This has arguably been very successful as unemployment in the UK has not risen as aggregate demand has fallen. Imagine if the policy response had been neoclassical: instead of the furlough scheme in the UK, what would have happened if the government just allowed things to ‘sort themselves out’? Eventually we would have bounced back, but at what cost?

Even so, there are still questions of how far governments around the world should go, and whether government spending has increased inflation. In the USA in 2021, for example, inflation has been on the rise as government-stimulated AD has run up against supply-side constraints. Despite the immediate need for Keynesian spending, it may be that the inflation that the neoclassical economists warned us against is still a threat.