Q. Assumptions of the AS-AD model?
The most significant change we make going from IS-LM model to AS-AD model is to allow P to be endogenous. As P was constant in IS-LM model, we must 'redo' IS-LM model allowing P to be endogenous. Here is a summary of changes which should be made and what won't change:
- Even if P is endogenous, we still presume that expected inflation is 0. Real interest rate r is consequently still equal to nominal interest rate R.
- There is no change in aggregate demand, YD(Y, R) = C(Y) + I(R) + G + X - Im(Y). None of the components would be a function of P for given values of Y and R.
- MD will rely positively on P in AS-AD model. In AS-AD model, demand for money is given by MD(Y, R, P). MD still relies positively on Y and negatively on R.
- Aggregate supply will be more complicated. In IS-LM model, aggregate supply was simply equal to aggregate demand though this is no longer the case in AS-AD model.
- Asreal wages are no longer constant, we should make a more detailed analysis of labor market.