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AD-AS (Aggregate Demand-Aggregate Supply) Model | Definition, Graphs & Examples

The Aggregate Demand-Aggregate Supply model, or AD-AS model, is one of the most fundamental in the field of macroeconomics. It provides us with a valuable way to analyse and understand the performance of the national economy, specifically the impact of various exogenous events on price levels and economic output or real gross domestic product (GDP). Why is that important? Well, as Robert Barro, Professor of Economics at Harvard, states in his book Intermediate Macroeconomics,  

Intermediate Macroeconomics

The performance of the overall economy matters for everyone because it influences incomes, job prospects and prices. (2017)

The AD-AS model looks at this through the lens of aggregate demand (AD) and aggregate supply (AS), which is the total demand and supply of goods and services in the economy. 

Analysing demand and supply in the aggregate is quite different from analysing demand and supply in microeconomic terms, which focuses on decision making at the individual or firm level. You can read our article on the differences between macroeconomics and microeconomics here. Using an aggregate demand and supply model like this, we can instead try to answer key questions like - what is the impact of increases in the price of oil on real GDP? What do changes in interest rates do to consumer spending? How does inflation or deflation affect national employment? Understanding the basic elements of the model is the first step.

What are the components of the AD-AS Model?

In the AD-AS model, the level of prices in the economy is shown on the vertical (Y) axis and real GDP, GDP adjusted for inflation, on the horizontal (X) axis. The X-axis is also commonly labelled as output or national income. A standard classical representation of the model consists of three curves: aggregate demand, short-run aggregate supply, and long-run aggregate supply, as in Figure 1 below.

Let’s look at those curves and their determinants in more detail.

This is a representation of the total demand for goods and services produced domestically in an economy over a set period of time. The determinants of the curve and the reason for its downward slope can be expressed as AD = C + I + G + (X - M), which means AD is the sum of consumer expenditure (C), investment (I), government spending (G), and exports (X) minus imports (M). It shows the inverse relationship between price levels and real GDP or output. For example, a fall in the price level will likely lead to an increase in consumer expenditure as consumers’ purchasing power increases (assuming wages remain constant), which in turn increases demand for output. Lower prices can also increase demand for exports, as exports become cheaper, which raises GDP. Finally, lower prices often mean lower interest rates, which also stimulates an increase in spending and investment. These effects are called the wealth effect, the net export effect, and the interest rate effect. 

This is a representation of the total supply of goods and services produced domestically in an economy over a certain period of time. You will notice that we differentiate between the short-run and the long-run AS curves. In the short-run, the AS curve slopes upwards, indicating that as prices increase firms will supply more and output will increase. This is because the SRAS curve is primarily determined by the costs of production in relation to the prices of products. It is assumed that in the short-run, the main costs of production, particularly wages, are “sticky”, meaning that they do not react quickly to changes in the price level. Therefore, if prices go up, while other costs remain stable, firms will be incentivised to produce more at the new price level in order to earn more profits, thereby increasing output. 

According to classical economists, in the long-run, the AS curve is vertical. This is because price levels do not affect long-run supply. It is assumed that the only factors affecting long-run output will be determinants of the size of the economy, namely labour, capital, natural resources, and technological capabilities. Therefore, output will be the same at any price level as the costs of production will have had time to fully adjust to new price levels, i.e. there is no “stickiness”. 

In Demystifying Global Macroeconomics, John Marthinsen explains that,

Demystifying Global Macroeconomics

It is essential to distinguish between endogenous variables that move an economy along these curves and exogenous variables that shift them. (2020)

 In the section above, we explained what causes movements along the curves, namely changes in price level, shown on the AD curve in Figure 2 below. Price level, as a variable, is endogenous to or dependent on the model. However, what many are interested in is how to shift the curves outwards or inwards. Shifts in the AD curve are shown in Figure 3 below. Shifts are caused by exogenous variables or variables external to the model. 

The AD curve shifts outwards or, indeed, retracts inwards, when there are changes in its underlying components, namely consumption, investment, government spending, or net exports (exports minus imports). There are multiple variables that could affect AD, here are just a few:

Taxation: tax cuts could increase consumer’s disposable income and therefore increase consumption. Tax rises would have the opposite effect.

Interest rates: a rise in interest rates could increase consumer’s propensity to save rather than consume, this would also increase the cost of investment, which would likely lead to less investment. 

Wealth levels: a stock market crash or a housing market crash would decrease consumer’s wealth and therefore consumption. 

Consumer or business confidence: high inflation can have a significant negative effect on consumer and business confidence, reducing propensity to spend and invest.

Exchange rates: a strong domestic currency relative to other currencies may stimulate imports and reduce exports as imports become cheaper and exports more expensive (assuming the price elasticity of imports and exports is high, i.e., sensitive to changes in price).


Aggregate Supply in the Short- and Long-run

Both the short- and long-run AS curves can shift either to the right or left, Figures 4 and 5 below. Shifts in the SRAS curve are mostly caused by factors influencing firms’ decisions on how much to produce, for example a change in the costs of production, particularly wages, changes in business confidence, changes to business taxes, government regulation changes, etc. For example, strike action that leads to a rise in wages (all other things remaining equal), may lead to a reduction in output. These types of supply shocks may well lead to a decrease in output, but are commonly passed onto consumers to some extent in the form of higher prices. 

The long-run aggregate supply curve (LRAS) is fixed at the economy’s natural level of output, which refers to the total output of an economy when all its resources are fully employed, including labour. In reality, full employment is a rare occurrence, but is a useful tool enabling analysis of the potential output of the economy against real output. The natural level of output could be affected by an increase in the size of the labour force, through a change in immigration policy allowing more foreign workers in, for example. This would be represented by a shift of the LRAS curve to the right. Other factors affecting natural levels of output could be the availability of resources or the productivity of its workforce. For example, if a country discovers untapped natural resources or acquires new technology that increases worker productivity, this could all increase potential output. 

Naturally, it is rare for factors that change AS or AD to occur in isolation. We need to analyse the interaction between AD and AS through changes in the point of equilibrium. The short-run equilibrium point is where the AD curve intersects with the SRAS curve and shows the level of prices and output in the economy at the current moment. Policy makers and central banks compare this to the point of long-run equilibrium, or where the AD curve intersects with the SRAS and LRAS curves.

This tool is used by governments and central banks to estimate the current state of the economy or the point we are at in the business cycle. Kevin Hoover puts it very succinctly in his comprehensive book on Applied Intermediate Macroeconomics, “the plans of aggregate suppliers and aggregate demanders are not automatically coordinated…The substance of macroeconomics concerns the problem of coordinating those plans.” (2011)

For example, in Figure 6, we see a situation in which the short-run equilibrium has shifted to the left of the long-run equilibrium. This is called a recessionary gap or a negative output gap, where output is less than the potential output of the economy. This could happen when a demand or supply shock causes output to drop. A negative output gap is typically caused by weak demand in the economy, leading to rising unemployment and deflation. 

In Figure 7, we see a positive output gap or inflationary gap, where the short-run equilibrium has shifted to the right. This is perhaps harder to imagine, how can we produce more than the potential output of the economy? A good example of this is working overtime. During an economic boom, AD can outstrip the point at which the economy is fully employing its resources (the LRAS curve), meaning firms need to pay overtime and workers will be asked to work extra hours to meet the demand. In this scenario, labour is working at a level over and above full employment and there is likely to be inflationary pressure on the economy. This is unsustainable over the long-term, firms will need to hire more workers to meet the demand, therefore, the LRAS curve will shift to the right and a new equilibrium will be found. 

In both cases, if these shifts are believed to be significant and sustained, governments will most likely be debating what they can do to close the output gap and help return the economy to equilibrium. Think of the recent COVID-19 epidemic, an excellent example of both demand and supply shocks acting on the global economy. In many economies around the world, the pandemic led to a sharp drop in output. Demand slumped as consumers were not allowed to leave their homes, uncertainty led consumers and investors to put off purchasing and investment decisions. Supply was also disrupted as workers could not come into work and global supply chains fell apart. In the UK, GDP fell 21.4% in the second quarter of 2020 compared to the average for 2019. This led to a policy response from the UK government, with massive increases in government spending to mitigate the worst of the downward pressure. 

Aggregate Supply or Aggregate Demand: The Big Debate

Was the government right to do this? The AD-AS model touches on one of the biggest debates in economics. To increase real GDP and raise living standards, should there be a strong government intervention? And if so, should they focus on increasing aggregate demand or aggregate supply? Which is the driver of economic output and which can help you when your country is heading for a recession? 

The Great Depression of the 1930s turned economic thinking on its head. Up to that point, classical economics or supply-side economics had reigned mostly due to the work of Jean-Baptiste Say. In his work, A Treatise on Political Economy, (1803 [2017]) he argues that supply precedes demand as to have demand a consumer must have first produced and earned money from that production in order to then consume other things.  This came to be known as Say’s Law.

In 1936, John Maynard Keynes, one of the most important people in modern economics, published The General Theory of Employment, Interest, and Money (1936 [2018]) as a counter to Say’s Law. He chastised earlier economists for:

The General Theory of Employment, Interest, and Money

having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand (1936 [2018])

Keynes believed that governments could reduce unemployment and increase GDP by stimulating demand as opposed to supply. 

It is important to note that he also disagrees with the classical representation of the AD-AS model (shown above), believing that rather than a SRAS and vertical LRAS, there is only one AS curve, which starts out horizontal and becomes vertical as output increases. This is to do with the elasticity of aggregate supply. A representation of the Keynesian AD-AS model is below and it is worth being familiar with both. 

The debate over the relative importance of AD as opposed to AS continues to this day and signifies the complexity of the national economy and responses to economic shocks. Nevertheless, the AD-AS model is worth understanding thoroughly as it remains a key tool for economists today in helping to make important policy decisions.

Further Macroeconomics reading on Perlego

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What is Capitalism? | Definition, History, Examples & Analysis

Capitalism is often seen as one of the defining features of the modern era. Typically classified as a type of economic system, the term indicates a system that organizes production and allocates resources through the market. But even the utterance of the word “capitalism” can spark heated debate, which begs the question: why is it so controversial? According to Nancy Fraser and Rahel Jaeggi in their book Capitalism: A Conversation in Critical Theory (2018),

Capitalism: A Conversation in Critical Theory

There is not only the question of varieties of capitalism [...] coexisting in different societies at the same time. In addition, we are confronted with the historical development of different stages of capitalism. There are tremendous differences between earlier configurations of capitalism and present-day capitalism.

In fact, rather than an economic system, they talk of a “capitalist society” and argue that “capitalism has social, economic, political dimensions that should be seen as standing in some kind of interconnected relation to each other.” Paul Bowles in his work on capitalism (2014) agrees that capitalism is systemic in nature, adding that,

Capitalism

Capitalism has [...] been subject to ‘non-naming’. It is common to find a variety of terms to describe the contemporary world: the ‘information age’, ‘post-industrial society’, the ‘free market economy’, the ‘global economy’, the ‘postmodern or post-colonial world’, the ‘consumer society’ or the ‘network society’, to name but some of them. In all of these terms, the word ‘capitalism’ is conspicuous by its absence; and yet, all of them implicitly presuppose a capitalist economy.

The reason for this "non-naming" of capitalism, according to Jürgen Kocka (2016) is that the word capitalism “emerged as a term of critique”. He states that,

Capitalism: A Short History

the term capitalism initially reflected above all [...] criticism of the class society, a usage that happened just as the term started to catch on in the middle of the nineteenth century, originally in French, then also in German beginning in the 1860s, and somewhat later in England.

At that time, the term was closely linked to prominent Western intellectuals, scholars, and philosophers of the day attempting to explain the changes in the world around them, including the breakdown of feudal societies, the emergence of modern market economies, and the changes brought about by the Industrial Revolution (1760-1840). 

This is particularly true of Karl Marx, who wrote extensively on the subject in the 1850s and 1860s. While he didn’t use the word "capitalism", his arguments centered around the "capitalist mode of production". Marx used this term to describe the capitalist system of private ownership of the means of production, particularly land, labor, and capital, by the dominant bourgeoisie class. He saw the capitalist system as a method of subjugation of the proletariat or working class, who were compelled to sell their labor power in order to make a living. 

To Marx, the concept of capitalism reflected an exploitative relationship between the capitalist and working classes, wherein the owners of the means of production could extract additional value or “surplus value” from this arrangement, for which the working classes were not compensated. As Marx explains in his seminal work, Das Kapital (1867 [2012]),

Das Kapital

The directing motive, the end and aim of capitalist production, is to extract the greatest possible amount of surplus-value, and consequently to exploit labor-power to the greatest possible extent. As the number of the cooperating laborers increases, so too does their resistance to the domination of capital, and with it, the necessity for capital to overcome this resistance by counter-pressure. The control exercised by the capitalist [...] is consequently rooted in the unavoidable antagonism between the exploiter and the living and laboring raw material he exploits.

For more on the Marxist critique of capitalism, please see our article “What is Marxism?”. As for capitalism itself, there has been renewed debate on the underlying nature of capitalism as well as its consequences in recent years. This has been led by several factors, including the rise of China as a global economic power, the 2008 Global Financial Crisis and escalating issues around wealth inequalities and environmental degradation. Pivotal to understanding these debates, is an understanding of what constitutes a capitalist system at a fundamental level and how it came to be the primary mode of organization for many countries around the world.

The fundamental characteristics of a capitalist system

As stated above, many equate capitalism with a system based on a free market economy, and while scholars generally list the existence of markets as one of the fundamental components of capitalism, that is not enough as a definition in and of itself. As Fraser and Jaeggi (2018) explain, this is because there are different “varieties of capitalism”, which have emerged over time as capitalist systems have propagated across the world. 

For example, among most capitalist systems there are different levels and modes of market freedom and regulation, as well as government intervention. At one end of the spectrum, market or laissez-faire capitalism indicates that governments play a minimal role in allocating resources and allow market forces to have free rein to organize economic activity (Bowles, 2014). At the other end, China’s current model is often called state capitalism (Hung and Chen, 2018), a market-based system, which is nevertheless governed by “powerful and frequent state intervention” and the dominance of state-owned enterprises. 

Distinctions have also been made between early forms of "merchant capitalism", which arose during the 17th century (Bowles, 2014) and later forms, such as "financial capitalism", which considers the now prominent role of financial markets in the organization of economic behavior (Tridico, 2017). However, in order to define capitalism many have attempted to identify the key characteristics that underly all capitalist systems. For example, Geoffrey Ingham (2013) in his book Capitalism, posits the following,

we can identify three fundamental elements, or institutional clusters, of the capitalist economy:

A. monetary system for producing bank-credit money; 

C. private enterprise production of commodities.

Others expand on this definition or emphasize other factors. For example, Kocka (2016) includes the existence of individual rights, particularly property rights, as essential for enabling “economic decisions in a relatively autonomous and decentralized way”. While Fraser and Jaeggi (Capitalism: A Conversation in Critical Theory, 2018), take a more Marxist slant, and focus on,

(1) a class division between owners and producers; (2) the institutionalized marketization and commodification of wage labor; (3) the dynamic of capital accumulation; and (4) market allocation of productive inputs and social surplus.

Definitions of capitalism are often influenced by the author’s interpretation of its history and development. Of course, how and why capitalism emerged is also much debated, but interpretations can be broadly grouped into two camps. On one side, there is a belief that capitalism came about through natural processes based on human instincts, particularly self-interest. While on the other side, there are those, including Marx, who did not see the emergence of capitalism as inevitable, but rather it was a violent process, brought about by the desire of the capitalist class for monetary profit (Thier, 2018). 

The "natural" argument dates back to Adam Smith (1723-1790), one of the founding fathers of economics. In his classic work, An Inquiry into the Nature and Causes of the Wealth of Nations (1776 [2021]), he argued that the "wealth of nations", or the prosperity enjoyed by certain countries, was due a natural human inclination towards a division of labor, led by a desire and ability to enter into exchange transactions. He stated that,

An Inquiry into the Nature and Causes of the Wealth of Nations

This division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another.

Critics of capitalism often dismiss the "natural" argument and focus on the historical factors that paved the way for capitalism to emerge. Thier (2018) points to the “Enclosure Movement”, a series of events, which ultimately removed peoples’ rights of access to and use of common land across the UK and other Western European countries. Thier argues that this left huge swathes of a previously feudal society without “means to maintain economic independence” and that, rather than freeing people from bondage, enclosure severed “the masses of people from access to land, tools, and resources” (2018). Capitalism, Thier argues,

A People's Guide to Capitalism

created a new underclass of wageworkers—a class of people theoretically free to work where and how they pleased, but who would in practice be compelled—by economic necessity—to produce a surplus for someone else nonetheless.

Ultimately, both advocates, like Smith and critics, like Marx, saw capitalism as a system driven by the profit motive, but while Smith believed this system “harmonized individual interests and collective social welfare”, Marx believed that the system produced crises and inequality (Ingham, 2013). 

The nature and future of capitalism has received renewed attention in recent decades and the phrase "crisis of capitalism" has become widespread. Why is this the case? As many argue, capitalism, globalization, and free market economics in the post-war era has generally reduced poverty and raised living standards across the globe. In an article published by McKinsey in 2020, entitled, “Rethinking the future of American capitalism”, James Manyika, Gary Pinkus, and Monique Tuin state that,

America’s brand of capitalism—the version that has been in place for the past half-century or so—has delivered unmatched economic growth and prosperity. GDP per capita has more than doubled over the past 50 years, while personal consumption expenditure per capita has almost tripled [...].

Rapid economic growth in emerging economies during the past 30 years has lifted a billion people out of poverty.

By "America’s brand of capitalism" the authors are referring to neoliberalism, a political and economic philosophy that arose in the 1960s and 1970s, championed by economists like Milton Friedman. Friedman not only argued that the type of free market capitalism prescribed by neoliberalists was the most efficient system in terms of the allocation of resources in an economy, he also believed that capitalism brought other benefits, namely that “capitalism is a necessary condition for political freedom” (Friedman, 1962 [2009]). Arguments in favor of neoliberalist policies are still prominent today, for example in debates around the extent to which markets, such as the markets for guns or drugs, should be regulated. 

Nevertheless, the capitalist system is facing a lot of scrutiny. In a speech made by Arundhati Roy in 2011, she points out that “’the American way of life’…has resulted in four hundred people owning the wealth of half of the population of the United States” (Roy, 2014). Statistics such as these have led people to ask the question: do systems led by the profit motive allocate resources fairly across all segments of society? In his widely celebrated book, Capital in the Twenty-First Century (2017), Thomas Piketty looks at the historical data available from the last three centuries and concludes that the capitalist system does not allocate resources fairly. As he states,

Capital in the Twenty-First Century

Modern economic growth and the diffusion of knowledge have made it possible to avoid the Marxist apocalypse but have not modified the deep structures of capital and inequality—or in any case not as much as one might have imagined in the optimistic decades following World War II. When the rate of return on capital exceeds the rate of growth of output and income, as it did in the nineteenth century and seems quite likely to do again in the twenty-first, capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based.

Piketty proposes the introduction of a progressive annual tax on capital as a solution to reducing inequality, essentially bringing the return on capital more in line with the rate of economic growth. Curbing capitalism’s excesses through tax and regulation is not a new idea. John Maynard Keyes argued just that back in the 1930s. He believed the capitalist system was inherently unstable due to speculative consumption and investment behavior driven by “animal spirits” rather than “mathematical expectation” and only governments could bring capitalism to heel. As we can see in Piketty’s analysis, government intervention as a solution has received renewed support in some quarters, particularly since the 2008 Global Financial Crisis. 

Others take a more radical view and see the beginning of the end for capitalism. For example, Robert Albritton argues that we are in the early stages of a transition away from capitalism (Westra, Badeen and Albritton, 2014), however, he does state that this could play out over several centuries. One thing is clear from the majority of works on capitalism: an agreed definition is hard to find. Capitalism means different things, to different people, at different times. In the present moment, it has perhaps become more of a shorthand to think about the inequalities that pervade the early 21st century - between the rich and the poor, between the colonizer and the colonized, between the people and the planet. While this understanding is alluring, it is perhaps simplistic. Capitalism has evolved over the centuries and will likely continue to evolve. In his book, Saving Capitalism (2016), Richard Reich suggests that the “basic rules of capitalism are not written in stone. They are written and implemented by human beings” and therefore, can be changed. 

The Protestant Ethic and the Spirit of Capitalism by Max Weber

The Economics and Sociology of Capitalism by Joseph A. Schumpeter, edited by Richard Swedberg

The Age of Surveillance Capitalism by Shoshana Zuboff

Capitalism: The Story Behind the Word by Michael Sonenscher

Bowles, P. (2014) Capitalism. 2nd edn. Taylor and Francis. Available at: https://www.perlego.com/book/1556229/capitalism-pdf   

Esping-Andersen, G. (2013) The Three Worlds of Welfare Capitalism. Polity Press. Available at: https://www.perlego.com/book/1535577/the-three-worlds-of-welfare-capitalism-pdf 

Fraser, N. and Jaeggi, R. (2018) Capitalism. Polity Press. Available at: https://www.perlego.com/book/1536438/capitalism-a-conversation-in-critical-theory-pdf

Friedman, M. (2009) Capitalism and Freedom. The University of Chicago Press. Available at: https://www.perlego.com/book/1853344/capitalism-and-freedom-fortieth-anniversary-edition-pdf 

Hung, J. and Chen, Y. (2018) The State of China’s State Capitalism. Springer Singapore. Available at: https://www.perlego.com/book/3485821/the-state-of-chinas-state-capitalism-evidence-of-its-successes-and-pitfalls-pdf   

Ingham, G. (2013) Capitalism. Polity Press. Available at: https://www.perlego.com/book/1535274/capitalism-with-a-new-postscript-on-the-financial-crisis-and-its-aftermath-pdf 

Kocka, J. (2016) Capitalism. Princeton University Press. Available at: https://www.perlego.com/book/738723/capitalism-a-short-history-pdf 

Manyika, J., Pinkus, G., and Tuin, M. (2020) “Rethinking the future of American capitalism”. McKinsey Global Institute. Available at: https://www.mckinsey.com/featured-insights/long-term-capitalism/rethinking-the-future-of-american-capitalism 

Marx, K. (2012) Das Kapital. Gateway Editions. Available at: https://www.perlego.com/book/784600/das-kapital-a-critique-of-political-economy-pdf 

Piketty, T. (2017) Capital in the Twenty-First Century. Harvard University Press. Available at: https://www.perlego.com/book/1133197/capital-in-the-twentyfirst-century-pdf 

Reich, R. (2016) Saving Capitalism. Icon Books. Available at: https://www.perlego.com/book/569539/saving-capitalism-for-the-many-not-the-few-pdf 

Roy, A. (2014) Capitalism: A Ghost Story. Verso UK. Available at: https://www.perlego.com/book/731067/capitalism-a-ghost-story-pdf 

Smith, A. and Icarsus (2021) An Inquiry into the Nature and Causes of the Wealth of Nations. Icarsus. Available at: https://www.perlego.com/book/2628240/wealth-of-nations-pdf 

Thier, H. (2018) A People’s Guide to Capitalism. Haymarket Books. Available at: https://www.perlego.com/book/1637090/a-peoples-guide-to-capitalism-an-introduction-to-marxist-economics-pdf   

Tridico, P. (2017) Inequality in Financial Capitalism. Taylor and Francis. Available at: https://www.perlego.com/book/1486027/inequality-in-financial-capitalism-pdf 

Westra, R., Badeen, D. and Albritton, R. (2014) The Future of Capitalism After the Financial Crisis. Taylor and Francis. Available at: https://www.perlego.com/book/715802/the-future-of-capitalism-after-the-financial-crisis-pdf 

What is Capitalism?

Monetarism | Defintion, Examples & Analysis

According to the famous monetarists Milton Friedman and Anna Schwartz, 

A Monetary History of the United States, 1867-1960

Money is a fascinating subject of study because it is so full of mystery and paradox. The piece of green paper with printing on it…will enable its bearer to command some measure of food, drink, clothing, and the remaining goods of life. (1963 [2008])

Among other things, monetarists assert that controlling the growth of the stock of money, or money supply, is vital for maintaining the stability of the economy. Friedman and Schwartz were not the first nor the last monetarists on the scene. Other notable proponents include Karl Brunner, who coined the term, at least two chairs of the Federal Reserve, Paul Volcker and Alan Greenspan, and even former British Prime Minister, Margaret Thatcher.

Generally, the rise of monetarism, which came to prominence in the 1970s and 80s, is seen as a direct response to the dominance of Keynesian economics in the post-war period. In A Concise History of Economic Thought [2016], Vaggi and Groenewegen state that, 

A Concise History of Economic Thought: From Mercantilism to Monetarism

[T]his critical stance towards contemporary Keynesian policy thinking is a crucial aspect of monetarism…Monetarism has therefore been accurately described as a counter-revolution in economics designed to restore money supply as a key macro-economic policy variable.

Because of this, you often see monetarism described, not in terms of its contributions to the advancements in economic thought, but rather in terms of its objections to Keynesianism. 

Today, economic theory and policy making is rarely divided neatly into proponents of monetarism and proponents of Keynesianism, but the legacy of their former battles remain. Take debates over how to set interest rates, the relative importance of monetary policy vs. fiscal policy in stabilising and growing the economy, or discussions about the relationship between inflation and unemployment. Monetarist theories did a lot to further our understanding of these issues. 

So, what exactly was the monetarist counter-revolution? Let’s start with an example.

Keynesianism vs. Monetarism: The Great Depression

A useful introduction to the two approaches can be seen in their explanations for the Great Depression (1929-1933). John Maynard Keynes, one of the most important figures in modern economics, horrified by the tragedy of the Great Depression, argued that its cause lay in a huge fall in aggregate demand. He proposed that government intervention to stimulate aggregate demand was the answer. He didn’t agree with the classical laissez-faire approach, i.e., that it is better to let market forces run their course as economies will naturally return to a position of equilibrium in the long run. He saw that as irrelevant, famously writing that: 

Instead, he believed that governments should play an active role in bringing economic stability, softening the ups and downs of the business cycle. Fiscal policy, which involves managing the economy primarily through adjusting government spending and tax policies, was his main tool. Many felt his arguments were borne out, as only massive government spending and other expansionary policies, driven by World War II, ended the period of the Great Depression. This led to the dominance of Keynesian economics from the 1950s onwards. 

As for Friedman and Schwartz, their investigations into the money supply led them to another interpretation. Their analysis showed that the Great Depression coincided with a huge drop in the money supply, which refers to the total currency and other liquid assets in the economy. They asserted that 

[T]he monetary collapse was not the inescapable consequence of other forces, but rather a largely independent factor which exerted a powerful influence on the course of events…The contraction is in fact a tragic testimonial to the importance of monetary forces.

They believed the way out of the Depression should have been through interventions to increase the supply of money. In their eyes, the blame for the economic collapse and its longevity sat squarely on the shoulders of the Federal Reserve and the banking system. 

In more general terms, they argued that changes in the money supply are not a result of changes in other economic variables, rather that “the direction of influence must run from money to income”. They concluded that the money supply has a direct influence on economic activity, indeed it determines the rate of economic growth. As to why they thought this, here the devil really is in the details. 

Let’s start with the Quantity Theory of Money. 

The theory that underpins monetarist explanations of the relationship between money supply and economic growth is the Quantity Theory of Money. This is often represented as:

V is the velocity of money (the rate at which money is exchanged in an economy), 

P is the average price for goods and services, 

and Q is the quantity of goods and services produced. 

Monetarists took V as relatively predictable, which was shown by Friedman and Schwartz’ work on the history of the money supply, therefore the money supply (M) becomes the main driver of prices and output, i.e., economic growth.

While Keynesian economists do not dispute the truth of this equation, they do dispute the argument that V is stable. If V is not stable, the relationship between money supply and economic output becomes much weaker. Keynesians do see a relationship between the money supply and Gross Domestic Product (GDP), however it’s an indirect relationship. An increase in the money supply can push down the interest rates (all other things remaining equal), which in turn can encourage consumption and investment, pushing up aggregate demand and ultimately driving economic growth. For pure Keynesians, it always comes back to the theory of aggregate demand. For more on how short- and long-run aggregate demand and supply works, see our article on the AD-AS Model. 

If we assume, as the monetarists did, that changes in the money supply are the main driver of changes in prices and output, we start to see the policy implications of monetarist theory. Friedman famously stated that “[i]nflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” His statement refers to the Quantity Theory of Money, i.e. if the growth of M rises faster than the growth of Y, there will be inflation. As the main goal of monetarist theory was to achieve economic stability in terms of growth and prices, the argument followed that policy should target a steady growth in the supply of money, matching it to expected economic growth rates, to achieve this. 

According to Greenlaw, Taylor, and Shapiro in Principles of Macroeconomics for AP Courses [2017], most monetarists actually advocated for minimal government intervention, believing that “with the long and variable lags of monetary policy, and the political pressures on central bankers, central bank monetary policies were as likely to have undesirable as to have desirable effects.” In their minds, the best method for minimising any undesirable effects was to create an explicit and fixed target for the growth of the money supply, which central banks would work to achieve over the long term. This would also keep inflation low and help to manage expectations of price and wage inflation, which they argued also affects economic activity. They did not agree with the Keynesian view that governments should use discretionary policy interventions to manage fluctuations in the short-term (as mentioned above, many Keynesians believed that the long run may never arrive). 

Money supply, inflation, and unemployment

Another area of debate was the relationship between inflation and unemployment. The main economic model used at the time was the Phillips curve, which posits a positive relationship between employment and inflation. This is on the basis that any attempt to reduce unemployment will have inflationary effects. The theory goes that the increase in demand required to achieve low unemployment would increase demand for labour and push up wages. These increased business costs would be passed onto the consumer by firms in the form of higher prices. 

As Sylvie Rivot explains in her book Keynes and Friedman on Laissez-Faire and Planning [2013], Keynesian economists used this to argue that policy makers could, 

Keynes and Friedman on Laissez-Faire and Planning

’Purchase’ lower unemployment through demand policy provided that ongoing inflation was tolerated…What is more, the relationship was considered reversible: the bargaining between inflation and unemployment could be done either way.

Figure 1 below shows a graphical representation of the Phillips curve. 

In the 1970s, the US and the UK experienced both high inflation and high unemployment, known as stagflation. Monetarists jumped on this as a failure of Keynesian theory. They argued that the Phillips curve did not account for several key principles. Firstly, they believed that individuals were not as “short-sighted” as Keynesians made them out to be. Individuals’ expectations need to be taken into account. 

Secondly, they concluded that the positive relationship between employment and inflation would only exist in the short term. In the long run, there would be no trade-off between unemployment and inflation as the unemployment rate would always shift back to its long run natural state. Figure 2 below shows these changes. 

Imagine that we are first at point A. This level of unemployment is deemed unacceptable to the government, therefore, policies to stimulate aggregate demand are put in place, which leads to more demand for labour and more employment. As a consequence, this drives up nominal wages, or wages that haven’t been adjusted for inflation, and, as explained above, causes inflation to rise. This is shown by a movement from point A to point B in Figure 2. Monetarists argue that workers will then take account of the higher inflation and realise that the purchasing power of real wages, or wages adjusted for inflation, has decreased. Thus workers will reduce the amount of labour they want to supply at this wage point and, unless real wages are increased, the curve will shift from SRPC1 to SRPC2. We have now gone from point B to point C; unemployment has shifted back to its original level but now with higher inflation. 

The monetary position on unemployment lays out the case for a ‘natural rate of unemployment’, which is where the actual rate of inflation and the expected rate of inflation are equal. This is the vertical long run Phillips curve in Figure 2 above. On this curve, the economy is at the natural rate of unemployment, where expectations are in line with the current rate of inflation. This again feeds the monetarist argument that governments should not attempt to micromanage the economy, rather the economy will self-regulate and return to the long-run state.

“The rapid inflation of the 1970s and early 1980s turned the nation’s attention away from the main concern of Keynesianism – unemployment – to the concern of Fisher and Friedman – inflation.” According to Brue and Grant in their book, The Evolution of Economic Thought [2012], this moment in history led to a major break with Keynesianism as monetarism rose to the fore.  To many policy makers it seemed that monetarists had the answers to the problems of inflation and slow economic growth. Leaders in both the US and the UK, namely the new Chairman of the Federal Reserve, Paul Volcker, and the then British Prime Minister Margaret Thatcher, put in place policies to reduce the money supply through setting targets around the money growth rate. The aim was also to reduce expectations around inflation in an attempt to reduce demands for higher wages. Interventions included raising interest rates, as well as cutting spending. 

While the policies were successful in cutting inflation, they also led to deep recessions in both the US and the UK, characterised by soaring unemployment. Strict monetarist policies were ultimately abandoned by both governments. The predictability of the velocity of money, which Friedman and Schwartz had charted across nearly a century, started to fail. A breakdown in the relationship between money supply, prices, and economic growth followed. The authorities at the time cited possible reasons, including changes to financial regulations and new financial innovations. However, they also argued that monetarist theories were incredibly difficult to put into practice.

As our understanding of economics has evolved, the dividing lines between different schools of economic thought have become less distinct. Despite the apparent failure of monetarist policies in the 1980s, monetarist ideas have had a profound effect on the development of economic theory and policy. For example, monetary policy remains an important tool for maintaining economic stability today. Although central banks abandoned targeting the money growth rate, inflation targeting, or setting an explicit target for inflation, has become the main policy of many central banks. The monetarist inclusion of expectations in economic theory and modelling has also been subsumed into mainstream thinking, along with other key ideas, such as the natural rate of unemployment and the long run vertical Phillips curve. Of course, the debates over the necessity and extent of government intervention still rage on.

Of course, as Brue and Grant put it, given the constant evolution of economic thought, “a final assessment of these contributions must await the scrutiny of our children and grandchildren.”

Recharting the History of Economic Thought

Brue, S and Grant, R. (2012) The Evolution of Economic Thought. Cengage Learning EMEA. https://www.perlego.com/book/801895/the-evolution-of-economic-thought-with-economic-applications-and-infotrac-2semester-printed-access-card-pdf

DeLong, J. (2000) ‘The Triumph of Monetarism?’ Journal of Economic Perspectives.https://pubs.aeaweb.org/doi/pdf/10.1257/jep.14.1.83 

Friedman, M and Schwartz, A. (2008) A Monetary History of the United States, 1867-1960. Princeton University Press. https://www.perlego.com/book/733854/a-monetary-history-of-the-united-states-18671960-pdf

Galbraith, J. (2008) ‘The Collapse Of Monetarism and the Irrelevance of the New Monetary Consensus.’ The Levy Economics Institute of Bard College. https://www.levyinstitute.org/pubs/pn_08_1.pdf 

Greenlaw, S, Taylor, T and Shapiro, D. (2017) Principles of Macroeconomics for AP® Courses 2e. OpenStax. https://www.perlego.com/book/695164/principles-of-macroeconomics-for-ap-courses-2e-pdf 

Kurz, H and Riemer, J. (2016) Economic Thought: A Brief History. Columbia University Press. https://www.perlego.com/book/773903/economic-thought-a-brief-history-pdf 

Jahan, S and Papageorgiou, C. (2014) ‘What is Monetarism?’ IMF. https://www.imf.org/external/pubs/ft/fandd/2014/03/pdf/basics.pdf  

Rivot, S. (2013) Keynes and Friedman on Laissez-Faire and Planning. Routledge. https://www.perlego.com/book/715468/keynes-and-friedman-on-laissezfaire-and-planning-pdf

Vaggi, G and Groenewegen, P. (2016) A Concise History of Economic Thought. Palgrave Macmillan. https://www.perlego.com/book/3499940/a-concise-history-of-economic-thought-from-mercantilism-to-monetarism-pdf 