AS/AD Model Study Notes

Chapter 11: The AS/AD Model

Key Topics

  • Combines macroeconomic concepts (growth, GDP, unemployment, inflation) into a unified model.

  • Explains short-run fluctuations in economic activity using AS/AD model.

  • Showcases interaction of aggregate supply and aggregate demand to reach macroeconomic equilibrium.

  • Provides a framework for economic policy goals: growth, low unemployment, low inflation, and associated tradeoffs.

  • Discusses shifts in AS/AD and government fiscal policy.

Economic Fluctuations

  • Economic fluctuations termed as the business cycle.

  • Expansion: Real GDP growth.

  • Contraction (Recession): Real GDP decline.

  • Fluctuations lack predictable patterns; difficult to forecast accurately.

Monitoring Macroeconomic Variables

  • Real GDP central for observing short-run economic changes.

  • Recession effects visible across macroeconomic data; real GDP and unemployment inversely related.

Perspectives on Supply and Demand

  • Economists debate importance of supply vs. demand in determining macroeconomic size.

  • Effective macroeconomic analysis requires consideration of both sides.

Say’s Law

  • "Supply creates its own demand" - income from sales subsequently stimulates demand.

  • Relevant mainly in long run; recessions indicate lack of immediate demand despite potential supply.

Keynes’ Law

  • "Demand creates its own supply" - GDP determined by total demand rather than just supply capacity.

  • Demand fluctuations significantly affect economic performance in the short run.

Assembling the AS/AD Model

  • AS/AD model defines total supply and total demand at macroeconomic level.

  • Aggregate Supply (AS): Total potential output at varying price levels, slopes upward.

  • Aggregate Demand (AD): Total spending on goods/services in the economy, slopes downward due to wealth, interest rate, and foreign price effects.

Equilibrium in the AS/AD Model

  • Intersection of AS and AD indicates equilibrium GDP and price level.

  • Potential GDP: Maximum output when resources utilize fully.

  • Short-run Equilibrium: Intersection of AD and SRAS; reflects actual economy output and price level.

  • Long-run Equilibrium: Determined by intersections involving LRAS at potential GDP; essential for sustained macroeconomic balance.

Shifts in AS/AD and Government Fiscal Policy

  • Shifts in Aggregate Demand (AD):

    • Increases in AD (rightward shift): Caused by factors such as:

    • Increase in consumer confidence or wealth.

    • Increase in investment spending.

    • Increase in government spending.

    • Increase in net exports.

    • Decreases in AD (leftward shift): Caused by factors such as:

    • Decrease in consumer confidence or wealth.

    • Decrease in investment spending.

    • Decrease in government spending.

    • Decrease in net exports.

  • Shifts in Aggregate Supply (AS):

    • Increases in AS (rightward shift): Caused by factors such as:

    • Decrease in input prices (e.g., oil prices, wages).

    • Improvement in technology or productivity.

    • Favorable supply shocks (e.g., good weather for agriculture).

    • Decrease in government regulations or taxes on production.

    • Decreases in AS (leftward shift): Caused by factors such as:

    • Increase in input prices.

    • Decline in productivity.

    • Unfavorable supply shocks (e.g., natural disasters).

    • Increase in government regulations or taxes on production.

  • Government fiscal policy (changes in government spending and taxation) can directly influence AD shifts.