Macro 3.5 & 3.6 AS/AD Equilibrium and Changes

Aggregate Supply and Aggregate Demand Model

• Overview of the Aggregate Supply and Demand curves and equilibrium in the economy.

• Relationship between price levels and real GDP, also known as national income.

Key Concepts

Axes of the Model

• Y-Axis: Price Level measured by the CPI or GDP deflator. Represents average prices in the economy.

• X-Axis: Real GDP represents GDP adjusted for inflation, also termed as national income (Y).

• As real GDP increases, employment rises and unemployment declines.

Curves in the Model

• Aggregate Demand Curve (AD):

  • Downward sloping, reflecting the inverse relationship between price level and real GDP.

  • Represents total spending across the economy.

• Short-Run Aggregate Supply Curve (SRAS):

  • Upward sloping, indicating a direct relationship between real GDP and price level due to sticky wages and prices in the short-term.

• Long-Run Aggregate Supply Curve (LRAS):

  • Vertical, indicating maximum sustainable output (YF) at full employment without cyclical unemployment.

  • Reflects conditions of no frictional or structural unemployment.

Equilibrium

• Short-Run Equilibrium:

  • Found at the intersection of AD and SRAS, leading to current price levels and real output (Y1).

  • Nominal GDP can be calculated by multiplying real GDP by the price level.

• Inflationary Gap:

  • Occurs when current output (Y1) exceeds long-run potential output (YF).

  • Indicates the economy is producing above full employment, leading to unemployment rates below natural levels.

• Recessionary Gap:

  • Occurs when current output (Y1) is less than YF.

  • Indicates operation below full employment, leading to unemployment rates above natural levels.

• Long-Run Equilibrium:

  • Occurs where LRAS intersects both AD and SRAS with current output equal to potential output (YF).

  • In this state, cyclical unemployment is zero, and unemployment equals the natural rate.

Changes in Aggregate Demand and Supply

Aggregate Demand Shocks

• Formula for GDP: C + I + G + NX.

  • Increases in any component shift the AD curve to the right, and decreases shift it to the left.

• Consumer Sentiment:

  • Positive sentiment shifts the AD curve to the right; negative sentiment shifts it to the left.

• Impact of Taxes and Interest Rates:

  • Increasing taxes decrease consumer spending and shift AD left; increasing interest rates reduce investments and consumption.

Effects of Aggregate Demand Shocks

• Positive AD Shock:

  • Shifts AD right, increasing real output and price levels; leads to demand-pull inflation.

• Negative AD Shock:

  • Shifts AD left, reducing real output and increasing unemployment while decreasing price levels.

Short-Run Aggregate Supply Shifters

• Input Prices:

  • Increases in input prices or production costs shift SRAS left.

• Resource Productivity:

  • Increases shift SRAS right, raising output.

• Business Taxes and Regulations:

  • Higher taxes and regulations shift SRAS left.

• Inflation Expectations:

  • Anticipating increased inflation can shift SRAS left due to rising wage demands.

Inflation Types

• Cost-Push Inflation:

  • Results from leftward shifts in SRAS, leading to lower output and higher price levels (stagflation).

Double Shifts in the AS-AD Model

• Scenario One (Increases in AD and SRAS):

  • Initial equilibrium (P1 and YF) shifts to increased output (Y2) and decreased price level (PL2), then AD shifts right again to yield final output (Y3) and price level (PL3). Real output increases but price level is indeterminate.

• Scenario Two (Increase in SRAS and Decrease in AD):

  • SRAS shift increases output but lowers price level; decline in AD will also decrease price level further.

  • Real output becomes indeterminate as one curve increases it while the other decreases.

Conclusion

• The AS-AD model manipulations have significant implications for economic understanding.

• For further practice, ReviewEcon.com offers resources and interactive features to solidify understanding.