Spain-Germany relationship: the AD-AS model
Introducing the AD-AS model
The AD-AS
or Aggregate Demand-Aggregate Supply model is a macroeconomic model that
explains price level and output through the relationship of aggregate demand
and aggregate supply. It is based on the theory of John Maynard Keynes
presented in his work The General Theory
of Employment, Interest, and Money.
Two
variables are represented by the model. The quantity variable on the horizontal
axis is now represented by real gross
domestic product (Y). This is the measure of the true value of annual
national production, and is adjusted for inflation. The level of price inflation P is represented on the upright axis. A suitable
economic statistic for this value would be the rate of inflation as determined
by the Implicit Price Deflator, the value used to compute real GNP from
nominal, inflated GNP.
Aggregate
demand is simply the total of all
levels of spending in the national income accounts; consumption, investment,
government purchases, and net exports.
The Aggregate Demand (AD) curve has a negative
slope: for a given level of Aggregate Demand set to AD1, the equation AD(P,Y) =
AD1 implies P = FAD1(Y) where FAD1 is a decreasing
function.
The Aggregate Supply (AS) curve shows how much output is supplied
by firms at various potential price levels. The Aggregate supply curve (AS
curve) describes for each given price level, the quantity of output the firms are willing to supply. The implied
function P = FAS1(Y) derived
from the supply equation AS(P,Y) = AS1 starts with a very low slope (derivative
close to zero) up to a certain level of GDP (Y*) where the slope tends to be very
steep.
Paul Krugman’s view on the European situation (NY Times blog)
"Given all that, the
current situation looks like this:
Spain is deeply
depressed, while Germany is close to full employment.
How can Spain restore
normal employment? The current European strategy is “internal devaluation”,
which means expecting Spain to cut wages and thereby restore competitiveness;
this can be represented as a downward shift in Spain’s AS curve (with the new
curve in red):
The trouble with this
strategy is twofold: it’s really, really hard to get wage cuts, and deflation
in Spain makes the problem of debt overhang worse.
What’s the alternative?
Aggressively expansionary monetary policy, which shifts the AD curves of both
countries to the right. This raises output and employment in Spain, but leads to
inflation in Germany."
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