Chapter 7 AD–AS and the Phillips Curve: A Baseline Disequilibrium Model

Abstract

We reformulate and extend the standard AD–AS growth model of the neoclassical synthesis (stage I) with its traditional microfoundations. The model retains an LM curve in the place of a Taylor interest rate rule, exhibits sticky wages as well as sticky prices, myopic perfect foresight of current inflation rates and adaptively formed medium-run expectations concerning the investment and the inflation climate in which the economy is operating. The resulting nonlinear five-dimensional (5D) model of labor and goods market disequilibrium dynamics avoids the striking anomalies of the standard AD–AS model of the neoclassical synthesis (stage I). It exhibits instead Keynesian feedback dynamics proper with, in particular, asymptotic stability of its unique interior steady state for low adjustment speeds and with cyclical loss of stability – by way of Hopf bifurcations – when some adjustment speeds are made sufficiently large, even leading to purely explosive dynamics soon thereafter. In this way, we obtain and analyze a baseline AD-D(isequilibrium) AS model with Keynesian feedback channels with a rich set of stability/instability features as sources of the business cycle. The outcomes of the model stand in stark contrast to those of the currently fashionable baseline model of the New Keynesian alternative (the neoclassical synthesis, stage II) that we suggest is more limited in scope.