Dr. Skousen is an economist at Rollins College, Winter Park, Florida 32789, and editor of Forecasts & Strategies, one of the largest investment newsletters in the country. For more information about his newsletter and books, contact Phillips Publishing Inc. at (800) 777-5005.

“The AS/AD model . . . is seriously flawed . . . a model of the worst type—a model that obscures, rather than clarifies.”[1]

—David Colander

Finally, a major academic economist has repudiated the dangerously flawed macro model used in all standard textbooks—the so-called Aggregate Supply (AS) and Aggregate Demand (AD) curves. David Colander, well-respected economics professor and author, has written a devastating critique of AS-AD macroeconomics in the latest issue of the prestigious Journal of Economic Perspectives, an official journal of the American Economic Association. What is more remarkable is that he considers himself a Keynesian “and proud of it,” yet he is in the forefront of revamping the way economics is taught.[2]

The teaching of macroeconomics needs a new approach on college campuses. A million and a half students study economics each year and they are receiving a heavy dose of bad economics, especially in the macro sections. The AS-AD model currently in vogue in virtually all textbooks[3] is a fatally flawed assault on free-market economics. To understand why, see the standard diagram of AS-AD analysis at the top of the next page.

The Fatal Flaw in Macroeconomics

What’s wrong with this model of the economy? First, it is rooted in the Keynesian theory that the free market cannot guarantee full employment. The diagram illustrates how the economy can allegedly be stuck forever at a high level of unemployment and recession. Note that point E, where aggregate demand and supply meet, is at less than full employment. By implication, increased government spending (the Keynesian prescription) can stimulate economic activity and push the AD curve forward until full employment is achieved, where the AS curve is vertical.

However, most economists now recognize that this old-fashioned Keynesian view of stagnation is fallacious. The free market will always achieve full-employment equilibrium as long as wages and prices are flexible and the government doesn’t engage in perverse monetary/fiscal policies.

Another problem with the AS-AD model arises when the economy reaches the point of full employment (where the AS curve is vertical). The model suggests that further deficit spending or inflating the money supply will only drive up prices without affecting real output. Yet numerous studies of countries suffering from runaway inflation demonstrate that inflation causes real output to fall also.

These are just a few of the many problems with the AS-AD model.

Professor Colander doesn’t address any of the criticisms mentioned above, however. Instead, he focuses on the inner- contradictions in the AD and AS curves themselves. Essentially, Colander shows how AS-AD analysis is internally inconsistent because it relies on contradictory assumptions. The supply relationships packed into AD are at war with the supply relationships underlying AS. Moreover, the textbook model implies that supply and demand are totally independent of each other in the aggregate economy, a theory that contradicts all common sense.

So what to do? Many of Colander’s colleagues favor complete banishment. Reuven Brenner, an economist at McGill University, not only dismisses textbook macro as “pseudo-science” but considers astrology as its closest allied field![4]

Needed: A New Macro Model

Yet Colander is afraid to scrap AS-AD entirely, and opts to salvage the faulty model in his current textbook, not because he is academically dishonest, but because he doesn’t have a legitimate alternative. A bad theory won’t disappear until you have a good theory to replace it with.

The problem remains: What can replace the AS-AD model? Austrian economics comes to the rescue! The stages-of production model developed by Ludwig von Mises and Friedrich Hayek offers an excellent alternative. My own four-stage macro model provides a graphic representation of the whole economy. It incorporates the two most important variables in the aggregate economy—what Roger Garrison, economics professor at Auburn University, labels “time and money.”[5] Professor Garrison and I are among those free-market economists attempting to develop the graphics of a new macroeconomic model. Stay tuned.

1. David Colander, “The Stories We Tell: A Reconsideration of AS/AD Analysis,” Journal of Economic Perspectives (Summer, 1995), pp. 169-188.

2. Professor Colander has been directly involved in two popular studies, The Making of an Economist, co-authored by Arjo Klamer (Westview Press, 1990), and Educating Economists, co-authored by Reuven Brenner (University of Michigan Press, 1992), both of which are damning critiques of the economics profession.

3. Paul Heyne’s Economic Way of Thinking (Macmillan, 1994, 7th edition) is the only exception, and it is regarded primarily as a micro text.

4. Reuven Brenner, “Macroeconomics: The Masks of Science and Myths of Good Policies,” Educating Economists, pp. 123-151.

5. Garrison has developed a fascinating graphical technique linking Keynesian and Austrian economics with a production- possibility curve. See Roger Garrison, “Linking the Keynesian Cross and the Production Possibilities Frontier,” Journal of Economic Education (Spring, 1995). For a full exposition of my 4-stage model, see my work, The Structure of Production (New York University Press, 1990), Part 2. This book also introduces an alternative form of aggregate supply and demand curves.