AS-AD in the Standard Dynamic Neoclassical Model: Business Cycles and Growth Trends

Abstract

The paper shows how a dynamic neoclassical AS-AD can be derived and used to describe business cycles and growth trends to undergraduates. Derived within the Ramsey-Cass-Koopmans (RCK) model, the AS-AD is the stationary equilibrium of the deterministic dynamic general equilibrium framework. The derivation first builds consumption demand, aggregate demand, and then aggregate supply through the equilibrium conditions and a closed form solution for the capital stock. Through a comparative static change in goods sector productivity, the paper shows the basic failing of the standard RBC model. Allowing a second comparative static change in the consumer’s time endowment captures a change in the "external margin" of labor supply. Combining these comparative statics enable explanation of the business cycle. Using the same comparative statics, with Solow exogenous growth, the AS-AD is derived along the balanced growth path equilibrium. "Solow-plus" facts of growth trends result, such as a trend up in education time and down in working time. Together this allows a fundamentally consistent AS-AD story of both stylized business cycles and growth trends.

Keywords: Ramsey-Cass-Koopmans, supply, demand, state variable

JEL Classification: A22, A23, E13