AS/AD Model Study Notes

Economics Revision: AS/AD Model

Definition and Overview of AS/AD Model

  • The AS/AD model is a macroeconomic model that elucidates the relationship between the price levels and output in an economy.

  • AS (Aggregate Supply) and AD (Aggregate Demand) represent the total supply and total demand in the economy, respectively.

  • The term "Aggregated" refers to the entire market, encompassing all goods and services, not limited to specific markets (e.g., not just the market for cats).

Macro Goals and Relationships

  • The AS/AD model illustrates the interplay among the three primary macroeconomic goals:

    • Growth

    • Unemployment

    • Inflation

  • This particular discussion focuses solely on economic growth.

  • Movements of the AS and AD curves can be utilized to forecast changes in two key indicators:

    • Gross Domestic Product (GDP)

    • Price Levels

Graphical Representation

  • The model is plotted with Real GDP on the X-axis and Price Levels on the Y-axis.

  • Both AS and AD curves will intersect, denoting a point called Equilibrium where Price Level (PL) equals Output (Y).

  • The core objective in exam scenarios is to identify which curve shifts and to explain the reasons behind such shifts, often represented through graphical shifts in the curves.

Understanding Aggregate Demand (AD)

  • The total real output demanded at various price levels indicates the total demand in the economy.

  • Factors Influencing AD Curve Shifts:

    • Consumption Spending (C)

    • Government Spending (G)

    • Investment (I)

    • Net Exports (X-M, where X = Exports and M = Imports)

    • The formula representing Aggregate Demand is:
      AD = C + I + G + (X - M)

    • Impact of Changes:

    • An increase in Consumption Spending leads to a rightward shift in the AD curve, while a decrease results in a leftward shift.

    • An increase in Investment also causes the AD to shift right, whereas a decrease shifts it left.

    • Government Spending increases shift the AD curve to the right; reductions result in a leftward shift.

    • An increase in Net Exports raises AD (right shift), and a decrease induces a left shift.

Understanding Aggregate Supply (AS)

  • Factors Influencing AS Curve Shifts:

    • Cost of Production

    • Cost of Imports

    • Productivity

    • Indirect Tax Rates

Causes of Leftward Shifts in AS

  • A leftward shift (decrease in output) occurs due to:

    • Increased Costs of Imported Raw Materials:

    • Higher costs lead to decreased production as companies face higher expenses to acquire raw materials.

    • Decrease in Productivity:

    • Factors like worker injuries or lack of skills result in lowered output, thus reducing supply.

    • Increase in Nominal Wages:

    • Rising wages mean higher production costs for firms, leading to decreased supply.

    • Increase in GST (Goods and Services Tax):

    • Higher taxes result in reduced production, hence a decrease in supply.

    • Rise in Oil Prices:

    • Oil is essential across industries; increased oil costs lead to increased production costs, thus decreasing supply.

Causes of Rightward Shifts in AS

  • A rightward shift (increase in output) occurs due to:

    • Decrease in Costs of Imported Raw Materials:

    • Lower costs allow businesses to obtain more raw materials, facilitating increased production and supply.

    • Increase in Productivity:

    • Enhanced skill levels or additional workforce enable higher production output, increasing supply.

    • Decrease in Nominal Wages:

    • Lower wages reduce production costs, allowing for greater production and increased supply.

    • Fall in Oil Prices:

    • A drop in oil prices lessens production costs, thereby enhancing production capacity and increasing supply.

Summary of Full Employment

  • Full Employment (Yf):

    • This condition indicates that all resources in the economy are utilized efficiently, maximizing productivity and output.