AS-AD Model

Definition

The AS-AD model, or Aggregate Supply-Aggregate Demand model, is a macroeconomic framework that explains price levels and output in an economy. It illustrates the relationship between aggregate supply (the total production of goods and services) and aggregate demand (the total spending on those goods and services) and how shifts in these curves can impact economic performance in both the short-run and long-run.

5 Must Know Facts For Your Next Test

1. In the short run, the AS curve can shift due to changes in resource prices, supply shocks, or changes in expectations about future inflation.
2. The AD curve can shift as a result of changes in consumer confidence, fiscal policy, monetary policy, or foreign demand for domestic goods.
3. Equilibrium in the AS-AD model occurs where the AD curve intersects with the AS curve, determining the overall price level and real GDP.
4. In the long run, the economy tends to move towards the potential output represented by the LRAS curve, which is vertical, indicating that changes in price levels do not affect real output.
5. The AS-AD model helps analyze economic fluctuations and guide policy decisions during periods of inflation or recession.

Review Questions

• How do shifts in the AD and AS curves affect equilibrium price levels and output in an economy?
  • Shifts in the AD and AS curves directly impact the equilibrium price level and output. For instance, if aggregate demand increases due to higher consumer confidence, the AD curve shifts to the right, leading to a higher equilibrium price level and increased output. Conversely, if aggregate supply decreases due to rising production costs, the AS curve shifts left, resulting in a higher price level but lower output. Understanding these shifts helps in predicting economic changes.
• Analyze how government policies can influence both short-run aggregate supply and aggregate demand within the AS-AD framework.
  • Government policies play a crucial role in influencing both SRAS and AD. For instance, expansionary fiscal policy—such as increased government spending or tax cuts—shifts the AD curve to the right, stimulating economic activity. On the other hand, supply-side policies aimed at improving productivity or reducing taxes on businesses can shift the SRAS curve to the right. These shifts can lead to lower unemployment and increased output but may also contribute to inflation if demand outpaces supply.
• Evaluate the implications of long-run aggregate supply being vertical in the context of potential GDP and economic growth.
  • The vertical nature of long-run aggregate supply (LRAS) indicates that in the long run, an economy's output is determined by its resources and technology rather than price levels. This means that while inflation may rise or fall due to demand fluctuations, actual economic growth depends on factors like labor force growth, technological advancements, and capital investment. Understanding this distinction is critical for policymakers aiming to promote sustainable growth without triggering inflationary pressures.

Related terms

Aggregate Demand (AD): The total demand for all goods and services in an economy at various price levels, reflecting consumer spending, investment, government spending, and net exports.

Short-Run Aggregate Supply (SRAS): The portion of the aggregate supply curve that reflects the production capacity of an economy at a given price level in the short run, where some input prices are fixed.

Long-Run Aggregate Supply (LRAS): The portion of the aggregate supply curve that represents the production capacity of an economy when all prices, including input prices, are flexible, indicating full employment output.