Some Pitfalls in the Conventional Treatment of Aggregate Demand

Abstract

In recent years, the aggregate demand-aggregate supply model has replaced the IS-LM framework as the dominant pedagogical tool for teaching macroeconomics. Of course, the IS-LM model is still used, but its primary function has been relegated to that of providing a convenient vehicle for deriving the aggregate demand curve. In the conventional derivation, price-induced changes in the real money supply shift the LM curve along a fixed IS schedule (absent wealth effects on consumption) and map out levels of output where aggregate demand and output are equal. Implicit in this approach is the assumption that output supplied by firms responds passively to aggregate demand whatever the price level.' But this passive response necessarily implies firms raise output in response to a decrease in the price level and lower output in response to an increase in the price level-a strikingly odd result that is fundamentally inconsistent with modem theories of aggregate supply. Our argument is that, for internal consistency, the aggregate demand curve must be derived using the aggregate supply curve that will eventually be paired with the aggregate demand curve to determine equilibrium price and output. The conventional aggregate demand curve does not meet this consistency test because the Keynesian assumption which generates the aggregate demand curve (i.e., that output responds passively to demand) is at variance with the supply response that is later paired with this aggregate demand curve. The inconsistency is obvious. Firms cannot both raise and lower output in response to a change in the price level. Clearly, the conventional approach to aggregate demand neglects serious consideration of the crucial role played by aggregate supply. Since output influences consumption expenditures, the aggregate demand curve cannot be derived independently of the supply-side of the economy. Therefore, rather than use the Keynesian assumption that output responds passively to demand, we derive the aggregate demand curve by incorporating a Lucas-type supply response, which