Unit 3 Deep Dive: Using AD-AS to Understand Equilibrium and Fiscal Policy

Aggregate demand–aggregate supply (AD-AS) model

A macroeconomic model used to determine equilibrium real GDP (output) and the price level by combining aggregate demand (AD) and aggregate supply (SRAS and LRAS).

Short-run equilibrium (AD-AS)

The point where aggregate demand (AD) intersects short-run aggregate supply (SRAS), determining the short-run equilibrium price level and real GDP.

Price level

An index of overall prices in the economy (the vertical axis in AD-AS graphs); it is not the inflation rate.

Aggregate demand (AD)

The total quantity of real GDP demanded at different price levels.

Downward slope of AD (three effects)

AD slopes downward due to the wealth effect (higher PL lowers real purchasing power), interest rate effect (higher PL tends to raise interest rates and reduce interest-sensitive spending), and foreign purchases effect (higher domestic PL reduces exports and increases imports, lowering net exports).

Aggregate expenditures identity

The spending decomposition of real GDP: Y = C + I + G + NX, where C is consumption, I is investment, G is government purchases, and NX is net exports.

AD shift vs. movement along AD

A change in the price level causes a movement along AD; a shift of AD requires a change in a non-price-level determinant of spending (e.g., C, I, G, NX drivers like confidence, taxes, foreign income, policy).

Short-run aggregate supply (SRAS)

The quantity of real GDP firms produce at different price levels in the short run, when some input prices (especially wages) are sticky.

Sticky wages (input price stickiness)

The short-run condition that nominal wages and some input prices do not adjust quickly, helping explain why SRAS slopes upward.

SRAS shift determinants

Factors that shift SRAS include changes in nominal wages, commodity/energy prices, other production costs, supply disruptions, and changes in productivity/technology.

Demand-pull vs. cost-push inflation

Demand-pull inflation comes from increased AD (often raising both output and PL in the short run); cost-push inflation comes from decreased SRAS due to higher production costs (often raising PL while lowering output).

Potential output (full-employment output)

The level of real GDP the economy can produce when resources are employed at normal rates (not zero unemployment), corresponding to the natural rate of unemployment.

Natural rate of unemployment

The unemployment rate that exists at potential output (includes frictional and structural unemployment, not cyclical).

Long-run aggregate supply (LRAS)

A vertical line at potential output; in the long run, wages and input prices adjust so the price level does not permanently change real output.

Long-run equilibrium (AD-AS)

When the AD–SRAS intersection occurs on LRAS, so equilibrium real GDP equals potential output and unemployment equals the natural rate.

Output gap

The difference between equilibrium real GDP and potential output: a recessionary gap occurs when output is below potential; an inflationary gap occurs when output is above potential.

Self-correction (AD-AS)

The built-in adjustment process where wage/input price changes shift SRAS to restore real GDP to potential output over time (SRAS right in a recessionary gap; SRAS left in an inflationary gap).

Discretionary fiscal policy

Deliberate changes in government purchases (G) and/or taxes to influence aggregate demand; it mainly works by shifting AD.

Expansionary fiscal policy

Fiscal policy used to close a recessionary gap by increasing G and/or decreasing taxes, shifting AD right and raising real GDP (and typically the price level).

Contractionary fiscal policy

Fiscal policy used to close an inflationary gap by decreasing G and/or increasing taxes, shifting AD left and lowering real GDP (and typically the price level).

Marginal propensity to consume (MPC)

The fraction of an additional dollar of income that households spend on consumption.

Spending multiplier (k)

The magnification of an initial change in spending: k = 1/(1 − MPC), and for government purchases ΔY = k·ΔG in the simplified model.

Tax multiplier (kT)

The effect of a tax change on output in the simplified model: kT = −MPC/(1 − MPC), so ΔY = kT·ΔT (negative sign indicates higher taxes reduce output).

Crowding out

When deficit-financed government borrowing raises interest rates and reduces private investment, partially offsetting the expansionary effect of fiscal policy on AD.

Automatic stabilizers

Fiscal features (like progressive income taxes and unemployment benefits) that automatically dampen business cycle swings by supporting spending in recessions and restraining spending in booms, without new legislation.