11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
3 min read•june 24, 2024
The AD/AS model is a powerful tool for understanding economic growth, unemployment, and inflation. It shows how shifts in and supply curves affect GDP, prices, and employment levels, helping explain recessions, expansions, and .
This model is crucial for policymakers to analyze economic shocks and guide decisions. It illustrates short-term fluctuations and long-term equilibrium, though it has limitations in capturing all real-world complexities like international trade and financial sector dynamics.
Economic Growth, Unemployment, and Inflation in the AD/AS Model
Economic growth in AD/AS model
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- Economic growth represented by rightward shift of (LRAS) curve
- Caused by technological advancements, increased productivity, capital accumulation (new factories, equipment)
- Increases and lowers price level
- Recessions represented by leftward shift of aggregate demand (AD) curve
- Caused by decreased consumer spending (job losses), reduced investment (business closures), declining exports (trade disruptions)
- Decreases and lowers price level
- Short-run equilibrium determined by intersection of and (SRAS) curve
- Rightward shift of AD curve leads to increase in real GDP and higher price level ()
- Leftward shift of AD curve leads to decrease in real GDP and lower price level ()
Unemployment and inflation effects
- Unemployment
- occurs with decrease in AD, causing recessionary gap
- Represented by leftward shift of AD curve, lowering price level and decreasing real GDP
- not directly represented in AD/AS model
- Caused by mismatch between skills of labor force and requirements of available jobs (automation, outsourcing)
- occurs when the economy reaches its
- occurs with decrease in AD, causing recessionary gap
- Inflation
- occurs with increase in AD, causing
- Represented by rightward shift of AD curve, raising price level and increasing real GDP
- occurs with increase in production costs, decreasing SRAS
- Represented by leftward shift of , raising price level and decreasing real GDP
- Inflation expectations can shift SRAS curve upward as workers and firms anticipate higher prices and adjust behavior (wage demands, pricing strategies)
- is a key goal of monetary policy to maintain low and stable inflation rates
- occurs with increase in AD, causing
Business Cycle and Economic Fluctuations
- The represents the recurring pattern of expansion and contraction in economic activity
- Stagflation occurs when there is high inflation and high unemployment simultaneously, often represented by a leftward shift of both AD and SRAS curves
- The natural rate of unemployment is the long-run consistent with full employment, where cyclical unemployment is zero
Significance of AD/AS for macroeconomics
- AD/AS model provides framework for analyzing effects of economic shocks on output, employment, and price level
- Helps policymakers understand consequences of fiscal and monetary policy decisions (government spending, interest rates)
- Identifies inflationary and recessionary gaps to guide policy responses (stimulus packages, austerity measures)
- Model illustrates relationship between short-run and long-run equilibrium
- Short run: economy can deviate from due to changes in AD or SRAS (oil price shocks, natural disasters)
- Long run: economy returns to potential output as prices and wages adjust to new equilibrium (market forces, government intervention)
- AD/AS model has limitations, simplifying complex economic relationships and not capturing all relevant factors
- Assumes closed economy, not accounting for international trade and capital flows (globalization, foreign investment)
- Does not explicitly model financial sector and its impact on real economy (banking system, stock market)
- Assumes is vertical, which may not always be the case in reality (hysteresis, supply-side policies)
Key Terms to Review (29)
Actual Output: Actual output refers to the real-world level of production or economic activity that is achieved in an economy, as opposed to the potential or ideal level of output. It is a key concept in the Aggregate Demand/Aggregate Supply (AD/AS) model, which analyzes how actual output is determined and how it relates to growth, unemployment, and inflation.
AD Curve: The Aggregate Demand (AD) curve represents the total demand for goods and services in an economy at different price levels. It depicts the relationship between the overall price level and the quantity of real output demanded, reflecting the combined demand from consumers, businesses, the government, and foreign buyers.
Aggregate Demand: Aggregate demand (AD) is the total demand for all final goods and services in an economy at a given time and price level. It represents the sum of four key components: consumer spending, business investment, government spending, and net exports. The concept of aggregate demand is central to understanding macroeconomic phenomena such as economic growth, unemployment, and inflation.
Aggregate Supply: Aggregate supply refers to the total quantity of goods and services that firms are willing to sell at different price levels in an economy during a specific time period. It represents the supply-side of the macroeconomic model and is a crucial component in understanding economic growth, inflation, and the business cycle.
Business Cycle: The business cycle refers to the periodic fluctuations in economic activity, characterized by alternating phases of expansion and contraction in measures of overall economic performance, such as GDP, employment, and inflation. It is a key concept in macroeconomics that helps explain and predict changes in the broader economy over time.
Contractionary Monetary Policy: Contractionary monetary policy refers to the actions taken by a central bank to slow down the pace of economic growth and curb inflationary pressures by tightening the money supply in the economy. This policy aims to reduce the availability of credit and increase interest rates, which can have significant impacts on various macroeconomic factors.
Cost-Push Inflation: Cost-push inflation is a type of inflation where the general price level rises due to increases in the production costs of goods and services. This is in contrast to demand-pull inflation, where prices rise due to increased consumer demand. Cost-push inflation is a significant factor in understanding how the U.S. and other countries experience inflation, as well as its impact on aggregate supply, the Phillips Curve, and inflation in various regions.
Cyclical Unemployment: Cyclical unemployment refers to the fluctuations in the unemployment rate that occur due to changes in the business cycle. It is the component of unemployment that rises during economic downturns and falls during periods of economic growth and expansion.
Demand-Pull Inflation: Demand-pull inflation is a type of inflation that occurs when the total demand for goods and services in an economy exceeds the total supply, causing prices to rise. This imbalance between demand and supply leads to a self-reinforcing cycle of increasing prices as consumers compete for limited resources.
Expansionary Fiscal Policy: Expansionary fiscal policy refers to government actions that are intended to stimulate economic growth, typically through increased government spending and/or reduced taxes. This policy approach aims to boost aggregate demand and support higher levels of employment, output, and inflation.
Full Employment: Full employment is an economic condition in which all or most of those who are able and willing to work are employed. It represents a situation where the unemployment rate is at or near its natural rate, indicating that the economy is operating at its maximum productive capacity without causing excessive inflationary pressures.
Inflation Rate: The inflation rate is a measure of the rate at which the general price level of goods and services in an economy increases over time. It is a crucial economic indicator that reflects the purchasing power of a currency and the overall cost of living for consumers.
Inflationary Gap: An inflationary gap refers to a situation where aggregate demand in an economy exceeds the economy's productive capacity, leading to upward pressure on prices and inflation. It represents a disequilibrium where the level of real GDP demanded is greater than the full employment level of real GDP.
Inflationary Growth: Inflationary growth refers to a situation where economic growth is accompanied by a persistent rise in the general price level or inflation. This phenomenon is often observed when an economy experiences strong demand-side pressures, leading to increased consumer spending and higher prices across various sectors.
Long-Run Aggregate Supply: Long-run aggregate supply (LRAS) refers to the relationship between the price level and the economy's total output when all input prices and production technologies have fully adjusted. It represents the maximum level of real GDP that can be produced when all resources are fully employed and all input prices have had time to adjust to the prevailing economic conditions.
LRAS Curve: The LRAS (Long-Run Aggregate Supply) curve represents the relationship between the price level and the quantity of output supplied in the long run. It depicts the maximum level of real GDP that an economy can produce at full employment, given the existing technology, capital stock, and labor force.
Natural Rate of Unemployment: The natural rate of unemployment is the level of unemployment that exists in an economy when it is at full employment, with all the available labor resources being used efficiently. It represents the unemployment rate that would prevail in the long run when the economy is in equilibrium, with no cyclical or structural distortions.
Okun's Law: Okun's Law is an empirical relationship that describes the inverse correlation between a country's unemployment rate and its gross domestic product (GDP) growth rate. It provides a framework for understanding the dynamic relationship between economic output and the labor market.
Phillips Curve: The Phillips Curve is an economic model that illustrates the inverse relationship between the rate of unemployment and the rate of inflation in an economy. It suggests that as unemployment decreases, inflation tends to increase, and vice versa.
Potential GDP: Potential GDP, also known as the full-employment level of GDP, represents the maximum sustainable level of output that an economy can produce when all available resources, including labor and capital, are fully utilized at their most efficient levels. It is the level of real GDP that an economy would achieve if it was operating at full employment without any inflationary pressures.
Potential Output: Potential output is the maximum level of real GDP that an economy can sustainably produce when labor, capital, and technology are fully employed without causing inflation to rise. It represents the economy's productive capacity and the highest level of output that can be achieved without overheating the economy.
Price Stability: Price stability refers to the maintenance of a low and steady rate of inflation over time, ensuring that the general level of prices in an economy remains relatively constant. It is a key macroeconomic goal for central banks and governments, as it promotes economic growth, employment, and financial stability.
Real GDP: Real GDP, or real Gross Domestic Product, is a measure of the total value of all goods and services produced within a country, adjusted for inflation. It provides a more accurate representation of economic growth and the standard of living by accounting for changes in prices over time, allowing for meaningful comparisons across different time periods.
Recessionary Gap: The recessionary gap refers to the difference between the economy's actual output and its potential output during a recession. It represents the shortfall in real GDP compared to the level of output the economy is capable of producing at full employment and optimal resource utilization.
Short-Run Aggregate Supply: Short-run aggregate supply (SRAS) refers to the relationship between the quantity of real output supplied and the general price level in the economy, in the short-term time frame. It represents the willingness and ability of producers to sell their products at different price levels, considering the constraints and conditions they face in the short run.
SRAS Curve: The Short-Run Aggregate Supply (SRAS) curve represents the relationship between the quantity of real output supplied and the price level in the short run, when at least one factor of production is fixed. It illustrates how producers will respond to changes in the price level while holding certain inputs constant.
Stagflation: Stagflation is a rare economic phenomenon characterized by the simultaneous occurrence of stagnant economic growth, high unemployment, and high inflation. It represents a situation where the economy experiences sluggish economic activity and rising prices, contradicting the typical inverse relationship between inflation and unemployment as described by the Phillips curve.
Structural Unemployment: Structural unemployment refers to a mismatch between the skills and qualifications of workers and the skills required by available jobs in the labor market. This type of unemployment is caused by fundamental shifts in the economy, such as technological advancements, changes in consumer demand, or the decline of certain industries, which can render some workers' skills obsolete or no longer in demand.
Unemployment Rate: The unemployment rate is a measure of the prevalence of unemployment and is calculated as the percentage of the total labor force that is unemployed but actively seeking employment and willing to work. It is a key economic indicator that provides insights into the health and performance of the labor market.