(7) AD-AS Model

Aggregate demand (AD)

The relationship between the overall price level and the total quantity of real GDP demanded by households, firms, government, and net exports.

Aggregate demand equation (national spending)

Y = C + I + G + NX

Wealth effect

When price levels fall, consumers’ purchasing power rises, so consumption increases.

Interest rate effect

When price levels fall, interest rates tend to decrease, encouraging more investment spending.

International trade effect

When domestic prices fall, exports rise and imports fall, increasing net exports.

Movement along AD curve

Occurs when the price level changes, holding all else constant.

Shift of AD curve

Occurs when factors other than the price level change (e.g. fiscal policy, expectations, foreign variables).

Factors shifting AD curve

1. Government policies (taxes, government purchases).

2. Expectations of households/firms.

3. Foreign variables (exchange rates, foreign income).

Long-run aggregate supply (LRAS)

The relationship in the long run between the price level and the quantity of real GDP supplied when the economy is at full capacity; vertical at potential GDP.

Why LRAS is vertical

In the long run, prices and wages fully adjust, so changes in the price level do not affect real GDP.

Factors shifting LRAS

Increases in labour, capital, or technology.

Short-run aggregate supply (SRAS)

The relationship between the price level and quantity of GDP supplied in the short run, when some prices/wages are sticky.

Why SRAS slopes upward

Because input prices rise more slowly than output prices; firms produce more when selling prices rise.

Sticky wages and prices

Wages and contracts adjust slowly, causing SRAS to slope upward.

Menu costs

Costs of changing prices (printing menus, updating catalogues), which make firms adjust slowly.

Movements vs shifts of SRAS

Movement = change in price level;

Shift = change in expectations, resource prices, or technology.

Factors shifting SRAS

1. Expected future price level.

2. Corrections of past errors.

3. Changes in natural resource prices.

Macroeconomic equilibrium

Occurs where AD = SRAS (short run); in long-run equilibrium, AD, SRAS, and LRAS intersect together.

Recession (AD decrease)

AD shifts left → output ↓ and unemployment ↑ in short run; price level ↓.

Expansion (AD increase)

AD shifts right → output ↑ and price level ↑ in short run; inflation may occur.

Automatic adjustment mechanism

Over time, SRAS shifts right (in a recession) or left (in an expansion) as wages and prices adjust back to potential GDP.

Supply shock

An unexpected event that shifts SRAS left (e.g. oil price spike); causes lower output and higher prices.

Stagflation

Combination of inflation (rising prices) and recession (falling GDP) due to a supply shock.

Dynamic AD–AS model

A version of the model allowing for continual growth (LRAS shifts right), rising AD, and inflation expectations.

Economic growth on AD–AS diagram

Shown by rightward shifts of LRAS and SRAS; if AD grows faster than LRAS, inflation occurs.

Q - The aggregate demand curve shows the relationship between the price level and real GDP demanded by:

D) all of the above

Q - Which of the following does NOT cause the AD curve to shift?

A) A change in the price level

Q - Government policies can shift AD to the right by:

C) increasing government purchases

Q - In the long run, an increase in the price level causes:

C) no change in real GDP

Q - Which of the following shifts both SRAS and LRAS?

B) Technological advanc

AD-AS Model

A model that explains short-run fluctuations in real GDP and the price level

An increase in interest rate…

shifts aggregate demand to the LEFT

• higher interest = raise costs of firms/households of borrowing, reducing investment and consumption spending

An increase in government purchases…

shifts aggregate demand to the RIGHT

• component of aggregate demand

An increase in personal/business tax

shifts aggregate demand to the LEFT

• consumption and investment falls when taxes rise

An increase in household’s expectations or their future incomes…

shifts aggregate demand to the RIGHT

• consumption spending increases

An increase in labour force or capital stock/resources…

shifts short-run aggregate supply curve to the RIGHT

• more output can be produced at every price

An increase in productivity…

shifts short-run aggregate supply curve to the RIGHT'

• costs of producing output fall

An increase in the expected future price level

shifts short-run aggregate supply curve to the LEFT

• workers and firms increase wages and prices

An increase in workers and firms adjusting (to having previously under-estimated the price level)

shifts short-run aggregate supply curve to the LEFT

• workers and firms increase wages and prices

An increase in the expected price of an important natural resource…

shifts short-run aggregate supply curve to the LEFT

• costs of producing output rise

Variables that shift the SR and LR aggregate supply curve

1. Increase in: labour force, capital stock, resources

2. Technological change