The Keynesian IS-LM model focuses on the "demand side" of the economy - the relationship between national income and the aggregate demand for product (goods and services) by consumers, producers, and governments. The IS-LM model ignores the price level of goods and services, the level of employment, the wage rate of workers, and the amount ofoutput of product. To include these macroeconomics aggregates in the model, I combine the labour market with the aggregate relationship between employment of workers and the level of output of product, providing the aggregate supply equation - a relationship between the price level and the level of output produced by firms. I also modify the equations that describe the money market of the basicIS-LM model to reflect the effect that changes in the price level have on the perceived "real supply" of money, yielding the aggregate demand equation - a relationship between the price level and the demand for output of firms.
The intersection of the aggregate demand and aggregate supply equations will yield the equilibrium level of output, the price level, the wage rate, and the level ofemployment, along with the rate of interest and the values of all the other macroeconomics variables obtained from the IS-LM model. This aggregate demand-aggregate supply (AD-AS) economics model tries to approximate the relationships among these key macroeconomics aggregates.
Below, I specify the functions (equations) that describe the aggregate activities of firms and workers in the production ofgoods and services: the production of output by firms from the factors of production, the private firms' demand for labour, and workers' supply of labour.
I set the values of the parameters of the macroeconomics functions to reflect the average values of the macroeconomics aggregates of the Canadian economy during the years of 1998 - 2003. (Statistics Canada: Gross domestic product, income-based;Gross domestic product, expenditure-based.) I express all macroeconomics aggregates in dollars, in billions of dollars.
In setting the values of these parameters, I have been concerned with obtaining a system of equations that fit the data (reasonably). If you have better estimates for the values of these parameters, you can modify the model within limits on the web page: Comparative StaticsOf The AD-AS Model.
The Aggregate Production Function.
The aggregate production function relates the amount of output produced in the economy to the amounts of inputs used, the amounts of labour, capital, and materials & supplies actively employed. Labour, capital, and materials & supplies are called the factors of production. Increasing the amount of any factor of production, while holdingconstant the other factors, will increase the amount of output. In this basic short-run AS-AD model, I consider the effect on output of varying the amount of labour employed, assuming materials & supplies vary in direct proportion to labour. Capital (more properly, capital services) are constant over the relevant time period of the model. The aggregate production function specifies the relationbetween labour inputs and the output of the firms in the economy. Since the contribution to output of one hour of labour employed depends on the type of job, and on the experience and education of the person employed, I assume I can convert the sum of all labour inputs into one generic labour input.
The productivity of labour is the average amount of output produced from one hour of genericlabour employed. Labour productivity is a function of the stock of capital, the experience and education of the labour force (called human capital), and the technology available to firms to produce output by efficiently using capital services with labour and materials & supplies inputs.
I approximate an economy's aggregate production function:
ys = ys(N, K, M)
showing that the value of...