Glossary

7.3 Equilibrium in the AD-AS Model

7 min read•august 15, 2024

The AD-AS model shows how the economy reaches equilibrium when meets . It's a key tool for understanding how changes in spending, production, and prices affect overall economic output and inflation.

This model helps explain real-world economic events like recessions and inflation. By analyzing shifts in the AD and AS curves, we can predict how things like government policies or supply shocks might impact the economy's and output.

Macroeconomic Equilibrium

Concept and Graphical Representation

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  • Macroeconomic equilibrium occurs when the quantity of demanded equals the quantity of real GDP supplied in an economy
  • Equilibrium is represented graphically by the intersection of the aggregate demand (AD) curve and the aggregate supply (AS) curve
  • In the short run, equilibrium may occur at a point where the economy is not at full employment
    • This can happen due to sticky wages and prices that prevent the economy from adjusting quickly to changes in demand or supply
  • In the long run, equilibrium tends to move towards the full employment level of output
    • As wages and prices adjust over time, the economy will gradually move towards its level
  • Macroeconomic equilibrium is a state where there is no tendency for change in the overall price level or real GDP, assuming no external shocks to the economy
    • At equilibrium, there is no pressure for prices or output to increase or decrease, as the quantities demanded and supplied are balanced

Short-Run and Long-Run Equilibrium

  • The (SRAS) curve is upward sloping due to sticky wages and prices
    • In the short run, firms may be unable to adjust their prices and wages quickly in response to changes in demand, leading to changes in output rather than prices
  • The (LRAS) curve is vertical at the full employment level of output
    • In the long run, wages and prices are fully flexible, and the economy will produce at its potential output level, which is determined by factors such as technology, capital stock, and labor force
  • Changes in the AD or AS curves will lead to a new equilibrium price level and output, which can be found by identifying the new intersection point of the curves
    • For example, an increase in AD (rightward shift) will lead to a higher equilibrium price level and output in the short run, as firms increase production to meet the higher demand

Equilibrium in AD-AS Model

Determining Equilibrium Price Level and Output

  • The equilibrium price level and output are determined by the intersection of the AD and AS curves
  • The AD curve represents the total quantity of goods and services demanded at each price level
    • Factors that can shift the AD curve include changes in consumption, investment, government spending, and net exports
  • The AS curve represents the total quantity of goods and services supplied at each price level
    • Factors that can shift the AS curve include changes in input prices, productivity, and the size of the labor force
  • To find the equilibrium price level and output, locate the point where the AD and AS curves intersect
    • At this point, the quantity of real GDP demanded equals the quantity of real GDP supplied, and there is no tendency for prices or output to change

Effects of Changes in AD and AS

  • A rightward shift in the AD curve (increasing aggregate demand) will lead to a higher equilibrium price level and a higher level of real GDP in the short run
    • This can be caused by factors such as increased consumer confidence, lower interest rates, or higher government spending
  • A leftward shift in the AD curve (decreasing aggregate demand) will lead to a lower equilibrium price level and a lower level of real GDP in the short run
    • This can be caused by factors such as decreased consumer confidence, higher interest rates, or lower government spending
  • A rightward shift in the SRAS curve (increasing short-run aggregate supply) will lead to a lower equilibrium price level and a higher level of real GDP
    • This can be caused by factors such as lower input prices or increased productivity
  • A leftward shift in the SRAS curve (decreasing short-run aggregate supply) will lead to a higher equilibrium price level and a lower level of real GDP
    • This can be caused by factors such as higher input prices or decreased productivity
  • Changes in the LRAS curve (long-run aggregate supply) will affect the full employment level of output but not the equilibrium price level in the long run
    • Factors that can shift the LRAS curve include changes in technology, capital stock, or the size of the labor force

Changes in AD and AS

Analyzing the Effects on Equilibrium

  • The AD-AS model can be used to analyze the effects of various economic shocks on macroeconomic equilibrium
    • Economic shocks are unexpected events that can disrupt the economy, such as changes in government policies, natural disasters, or shifts in consumer behavior
  • Changes in government spending and taxes () can shift the AD curve and affect the equilibrium price level and output
    • Expansionary fiscal policy (increasing government spending or decreasing taxes) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
    • Contractionary fiscal policy (decreasing government spending or increasing taxes) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
  • Changes in the money supply () can also shift the AD curve and affect the equilibrium price level and output
    • Expansionary monetary policy (increasing the money supply) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
    • Contractionary monetary policy (decreasing the money supply) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
  • Supply shocks, such as changes in energy prices or natural disasters, can be represented by shifts in the SRAS curve and their effects on equilibrium can be analyzed using the AD-AS model
    • For example, a negative (leftward shift in SRAS) due to a natural disaster will lead to a higher equilibrium price level and lower output in the short run

Long-Run Adjustments

  • In the long run, the economy will tend to move towards its full employment level of output, as prices and wages adjust to changes in demand and supply
    • The LRAS curve represents the full employment level of output, which is determined by factors such as technology, capital stock, and the size of the labor force
  • Changes in the AD curve will not affect the long-run equilibrium output level, as the LRAS curve is vertical
    • In the long run, changes in AD will only affect the price level, not the level of output
  • However, changes in the LRAS curve (long-run aggregate supply) will affect the full employment level of output
    • Factors that can shift the LRAS curve include changes in technology, capital stock, or the size of the labor force
    • A rightward shift in the LRAS curve (increasing long-run aggregate supply) will lead to a higher full employment level of output, while a leftward shift (decreasing long-run aggregate supply) will lead to a lower full employment level of output

AD-AS Model Applications

Fiscal and Monetary Policy

  • The AD-AS model can be used to explain and predict the effects of fiscal policy on macroeconomic equilibrium
    • Expansionary fiscal policy (increasing government spending or decreasing taxes) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
      • For example, during a recession, the government may increase spending on infrastructure projects to stimulate demand and boost output
    • Contractionary fiscal policy (decreasing government spending or increasing taxes) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
      • For example, during a period of high inflation, the government may reduce spending or raise taxes to cool down the economy and reduce inflationary pressures
  • The AD-AS model can also be used to analyze the effects of monetary policy on macroeconomic equilibrium
    • Expansionary monetary policy (increasing the money supply) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
      • For example, during a recession, the central bank may lower interest rates or engage in quantitative easing to increase the money supply and stimulate demand
    • Contractionary monetary policy (decreasing the money supply) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
      • For example, during a period of high inflation, the central bank may raise interest rates to reduce the money supply and cool down the economy

Real-World Economic Phenomena

  • The AD-AS model can be used to understand and explain real-world economic phenomena, such as recessions, inflation, and
    • Recessions can be explained by a leftward shift in the AD curve, leading to a lower equilibrium price level and output
      • This can be caused by factors such as decreased consumer confidence, higher interest rates, or lower government spending
    • Inflation can be explained by a rightward shift in the AD curve or a leftward shift in the SRAS curve, leading to a higher equilibrium price level
      • Factors that can cause inflation include increased government spending, lower interest rates, or higher input prices
    • Stagflation, a combination of high inflation and low economic growth, can be explained by a leftward shift in the SRAS curve, leading to a higher price level and lower output
      • This can be caused by factors such as supply shocks (oil price increases) or decreased productivity
  • By examining the underlying shifts in the AD and AS curves, policymakers can develop appropriate responses to economic challenges
    • For example, during a recession, policymakers may implement expansionary fiscal or monetary policies to stimulate demand and boost output
    • During a period of high inflation, policymakers may implement contractionary fiscal or monetary policies to cool down the economy and reduce inflationary pressures

Key Terms to Review (18)

AD-AS Curve: The AD-AS curve represents the aggregate demand and aggregate supply model in economics, illustrating the total demand for goods and services at various price levels in an economy. This model is essential for understanding how different economic factors, such as inflation and unemployment, interact to determine the overall level of economic activity and the equilibrium point where aggregate demand equals aggregate supply.
Aggregate Demand: Aggregate demand represents the total demand for all goods and services in an economy at a given overall price level and in a given time period. It is a critical component in understanding how various factors, including consumption, investment, and government spending, interact to influence economic activity and overall demand in the economy.
Aggregate Supply: Aggregate supply refers to the total quantity of goods and services that producers in an economy are willing and able to sell at a given overall price level in a specific time period. It is influenced by factors such as production capacity, labor, and technology, and plays a crucial role in understanding economic output and the overall health of an economy.
Classical theory: Classical theory is an economic perspective that emphasizes the idea that free markets, driven by supply and demand, naturally lead to full employment and efficient allocation of resources. This theory posits that markets are self-regulating and that any unemployment or output gaps are temporary, as wages and prices adjust quickly to changes in supply and demand conditions.
Demand shock: A demand shock is an unexpected event that causes a sudden increase or decrease in demand for goods and services within an economy. This shift in demand can lead to significant changes in output, prices, and overall economic activity, as businesses and consumers adjust to the new demand levels. Understanding how demand shocks influence economic equilibrium, shift aggregate demand and supply curves, and interact with the multiplier effect is crucial for analyzing economic fluctuations.
Equilibrium point: The equilibrium point is the state where aggregate demand equals aggregate supply in the economy, resulting in stable prices and output levels. At this point, there is no inherent tendency for change, meaning that the overall economy is balanced, and neither shortages nor surpluses exist. It represents a crucial concept in understanding economic fluctuations and policy implications.
Equilibrium price level: The equilibrium price level is the price at which the quantity of goods and services demanded equals the quantity supplied in an economy. This price level is determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves, reflecting the overall economic conditions. It plays a crucial role in determining inflation rates, employment levels, and economic growth.
Fiscal Policy: Fiscal policy refers to the use of government spending and taxation to influence the economy. It plays a crucial role in managing economic activity, affecting levels of demand, inflation, and overall economic growth by adjusting public expenditure and revenue collection.
Inflation Rate: The inflation rate is the percentage increase in the general price level of goods and services over a specific period, typically measured annually. It reflects how much prices have risen compared to a previous time frame, influencing purchasing power, economic stability, and monetary policy decisions.
Keynesian Theory: Keynesian Theory is an economic theory that emphasizes the role of government intervention and aggregate demand in influencing economic activity and managing business cycles. It posits that during periods of economic downturn, increased government spending and lower taxes can stimulate demand, helping to reduce unemployment and boost economic growth.
Long-run aggregate supply: Long-run aggregate supply refers to the total output of goods and services that an economy can produce when utilizing its resources fully and efficiently, irrespective of the price level. This concept emphasizes that in the long run, the quantity of goods supplied is determined by factors such as technology, resources, and labor, rather than prices. It is depicted as a vertical line on the aggregate demand and supply model, indicating that changes in price levels do not affect the total output in the long run.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to manage the money supply and interest rates in order to achieve specific economic goals, such as controlling inflation, stabilizing currency, and fostering economic growth. This policy plays a crucial role in influencing overall economic activity and can be adjusted to respond to changing economic conditions.
Potential Output: Potential output refers to the highest level of economic activity that an economy can sustain over the long term without increasing inflation. It represents the maximum productive capacity of an economy when all resources are used efficiently. This concept is crucial as it helps identify the output gap, which is the difference between potential output and actual output, and is tied to understanding economic cycles and labor markets.
Real GDP: Real GDP is the total value of all goods and services produced in an economy, adjusted for changes in price or inflation over time. This adjustment allows for a more accurate comparison of economic output across different time periods, reflecting the true growth of the economy without the distortions caused by rising prices. Understanding Real GDP is essential as it ties directly into how we measure economic performance, analyze growth patterns, and assess the overall health of an economy.
Recessionary gap: A recessionary gap occurs when an economy's actual output is lower than its potential output, leading to increased unemployment and underutilized resources. This situation indicates that the economy is not operating at full capacity, and it typically arises during economic downturns or recessions. The presence of a recessionary gap highlights the need for policy interventions to stimulate demand and restore full employment.
Short-run aggregate supply: Short-run aggregate supply (SRAS) refers to the total quantity of goods and services that firms in an economy are willing and able to produce at a given overall price level, assuming that some production costs are fixed in the short run. In this context, the SRAS curve is typically upward sloping, indicating that as prices increase, the quantity of goods supplied also increases due to higher profitability for firms. This relationship plays a crucial role in determining economic equilibrium and helps distinguish between classical and Keynesian views on how economies adjust to changes in demand and supply.
Stagflation: Stagflation is an economic condition characterized by stagnant economic growth, high unemployment, and high inflation occurring simultaneously. This paradoxical situation challenges traditional economic theories, as inflation typically occurs during periods of economic growth, making it difficult to implement effective policies.
Supply shock: A supply shock is an unexpected event that suddenly changes the supply of a product or commodity, leading to significant shifts in prices and economic activity. These shocks can result from natural disasters, geopolitical events, or sudden changes in production costs, affecting the overall economy by shifting the aggregate supply curve. This change can influence inflation and output levels, creating ripples throughout economic indicators.
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