The AS–AD Framework: Origins, Problems and Progress

In this chapter we reformulate and extend the traditional AS–AD growth dynamics of the Neoclassical Synthesis, stage I with its traditional microfoundations, as it is for example treated in detail in Sargent (1987, Chap. 5). Our extension in the first instance does not replace the LM curve with a now standard Taylor rule, as is done in the New Keynesian approaches (however this is treated in a later section of the chapter). The model exhibits sticky wages as well as sticky prices, underutilized labor as well as capital, myopic perfect foresight of current wage and price inflation rates and adaptively formed medium-run expectations concerning the investment and inflation climate in which the economy is operating. The resulting nonlinear 5D dynamics of labor and goods market disequilibrium (at first—in comparison with the old neoclassical synthesis—with a conventional LM treatment of the financial part of the economy) avoids striking anomalies of the conventional model of the Neoclassical synthesis, stage I. Instead it exhibits Keynesian feedback dynamics proper with in particular asymptotic stability of its unique interior steady state solution for low adjustment speeds of wages, prices, and expectations. The loss of stability occurs cyclically, by way of Hopf bifurcations, when these adjustment speeds are made sufficiently large, leading eventually to purely explosive dynamics.