The aggregate demand and aggregate supply (AD/AS) model

AD-AS model

Explains how the overall price level (p) and total output (y) in an economy are determined in the short run and long run.

• framework for analysing monetary and fiscal policy

Aggregate demand (AD) curve

Downward sloping relationship between π and Y.

• position determined by monetary and fiscal policy, demand shocks

Aggregate supply (AS) curve

Upward sloping relationship between π and Y.

• position determined by inflation expectations (fixed), supply shocks

Two components that make up the aggregate demand curve

1. Relationship between output Y and real interest rates r

2. Relationship between inflation π and real interest rates r (monetary policy reaction function)

If there is an increase in π what is the central banks response (what happens to r) and how does it affect Y?

Central banks increase real interest rate (cost more to borrow, greater returns when saving), Y decreases as demand decreases

Consumption function to include real interest rate formula?

c̄ + c(Y-T)-γcr, γc>0

What does this γc>0 represent?

Measures interest sensitivity of consumption

Investment function to include real interest rate r formula?

i - γir, γi>0

What does this γi>0 represent?

Measures interest sensitivity of investment

What happens to investment demand if real interest rate r increases?

Reduces investment demand as fewer projects are profitable due to 

• higher cost of borrowing

• higher opportunity cost of investment

Monetary Policy Reaction Function

Central bank increases interest rates in response to inflation.

Monetary Policy Reaction Function Formula

i = r* + π + α(π-π*)

i = policy interest rate (nominal)

r* = natural real rate

α = sensitivity of central banks policy rate to inflation gap

π* = central bank inflation target

AD curve formula (short-run)

Y-Y* = -αγ(π-π*)+ed

Two components that make up aggregate supply curve

1. Relationship between unemployment u and inflation π (Phillips curve, Natural rate hypothesis)

2. Relationship between unemployment u and real output Y (Okun’s law)

When output Y increases what happens to unemployment and inflation?

Unemployment u decreases and inflation rises

What does phillips curve say?

Lower unemployment —> higher inflation (firms compete for workers, wages rise faster)

Higher unemployment —> lower inflation

Why does lower unemployment lead to increase in inflation?

As labour markets get higher (scarcer workers), wages rise, business costs rise and hence prices rise

Phillips curve formula

π = π^e - Ø(u-u*) +es

π^e = inflation expectations

Ø = inflation sensitivity to labour market tightness

es = supply shocks

Okun’s law

Inverse relationship between output gap and cyclical unemployment

u-u* = -B(Y-Y*)

SRAS curve

π = π^e +ØB(Y-Y*) +es

LRAD curve

Y-Y* = -αγ(π-π*)

LRAS curve

π = π +ØB(Y-Y*) +es

Types of temporary shocks

• investment boom

• confidence slump

• energy price hike

Types of permanent shocks

• increase in natural output

• decrease in inflation target