Criticism of AS-AD model -- Does it really work in real world?

The aggregate demand–aggregate supply (AD-AS) framework has dominated macroeconomics textbooks since the 1980s. However, there have been significant criticisms of the AD-AS framework, beginning in the 1990s. Let's look at one of the criticisms drawn by an economist.

One important criticism of the AD-AS theory is that it is empirically unrealistic. The main unrealistic features of AD-AS are: (1) it assumes that when prices fall, the short-run equilibrium output is less than the full employment “natural” level of output. (2) Furthermore, and more importantly, the AD-AS theory also assumes that this decline in the price level is good for the economy, i.e. it would increase AD and the economy would return to the full employment equilibrium price level and quantity of output in the long run, with only minor difficulties.

Both of these two assumptions are extremely unrealistic. In the first place, prices hardly ever fall anymore; the last time the price level fell in the United States was in 1955, and then only a tiny bit. And yet the level of output has been less than the full employment natural output for most of the post-World War II period! Therefore, a theory that assumes that {Y < full employment Y} causes prices to fall has a serious disconnect with contemporary economic reality.

Even more importantly, even if prices were to fall, this “deflation” would not increase AD and would not provide an unproblematic return to full employment output, but would instead be a disaster, especially for a heavily indebted economy, such as the U.S. economy. Falling prices would increase the real debt burden of borrowers, which would increase delinquencies and bankruptcies, which in turn would cause a financial crisis and a significant reduction of AD (both C and I). Thank goodness that prices do not fall as AD-AS theory predicts! If prices did fall, we would really be in trouble. A theory that concludes that falling prices will provide an unproblematic return to full employment equilibrium has an even more serious disconnect with reality than the assumption of falling prices itself. Deflation is the greatest fear of most macroeconomists today, and yet macroeconomists still continue to teach the AD-AS model, with the same old unrealistic conclusions about the positive effects of deflation.

Graphically, this “bankruptcy effect” of deflation would reduce AD (both C and I) and make the AD curve positively sloped, rather than negatively sloped. The negative slope of the conventional AD curve is due to the Keynes effect (lower real rate of interest → higher investment spending) and (perhaps) to the Pigou effect (higher real balances → higher consumer spending). However, these two effects are likely to be small (especially the Pigou effect) and overwhelmed by the “bankruptcy effect” of deflation on both investment spending and consumer spending.