The aggregate demand-aggregate supply model

The aggregate demand-aggregate supply (AD-AS) model is a framework economists use to show the relationship between the overall price level in an economy and the total output of goods and services. This model helps explain how changes in economic conditions affect key variables like output, employment, and prices. It focuses on the economy as a whole rather than individual markets.

Key components of the AD-AS model

• Aggregate demand (AD) - The total demand for all goods and services in an economy at different price levels. It includes spending by households, businesses, governments, and foreign buyers. The AD curve slopes downward because higher prices reduce purchasing power and make exports less competitive.
• Short-run aggregate supply (SRAS) - The total supply of goods and services that firms are willing to produce in the short run at different price levels. The SRAS curve slopes upward because higher prices encourage firms to produce more, assuming some input costs remain fixed.
• Equilibrium - The point where the AD and SRAS curves intersect, determining the economy's overall price level and output level.

This model illustrates macroeconomic equilibrium. Changes, known as shocks, can shift these curves and alter the equilibrium in the short run, which is a period where some factors like wages or contracts cannot adjust immediately.

Effects of aggregate demand shocks in the short run

An aggregate demand shock is a sudden change that shifts the AD curve, affecting the economy's output, employment, and price level. These shocks can be positive, increasing demand, or negative, decreasing it. As a result, the economy moves to a new short-run equilibrium.

Positive aggregate demand shock

A positive shock increases AD, often due to factors like higher consumer spending or government stimulus. This shifts the AD curve to the right.

Effects of a positive AD shock:

• Output - Rises as firms produce more to meet increased demand.
• Employment - Increases because firms hire more workers to boost production.
• Price level - Goes up due to higher demand putting pressure on available resources.

In the AD-AS diagram, this rightward shift in AD leads to a higher equilibrium output and price level.

Negative aggregate demand shock

A negative shock decreases AD, possibly from events like reduced investment or a financial crisis. This shifts the AD curve to the left.

Effects of a negative AD shock:

• Output - Falls as demand for goods and services drops.
• Employment - Decreases with lower production leading to layoffs or reduced hiring.
• Price level - Declines because excess supply creates downward pressure on prices.

In the AD-AS diagram, this leftward shift in AD results in lower equilibrium output and price level.

These changes highlight how demand-side shifts can lead to economic expansions or recessions in the short run.

Effects of short-run aggregate supply shocks

A short-run aggregate supply shock shifts the SRAS curve, often from changes in production costs or resource availability. Positive shocks make production easier, while negative ones make it harder. These shifts create a new short-run equilibrium.

Positive short-run aggregate supply shock

A positive shock increases SRAS, such as from lower input prices or technological improvements. This shifts the SRAS curve to the right.

Effects of a positive SRAS shock:

• Output - Increases as firms can produce more at the same cost.
• Employment - Rises with expanded production requiring more labor.
• Price level - Falls because greater supply meets demand at lower prices.

In the AD-AS diagram, this rightward shift in SRAS leads to higher output but a lower price level.

Negative short-run aggregate supply shock

A negative shock decreases SRAS, often due to higher costs like rising oil prices or supply chain disruptions. This shifts the SRAS curve to the left.

Effects of a negative SRAS shock:

• Output - Decreases as higher costs limit production.
• Employment - Falls because reduced output means less need for workers.
• Price level - Rises due to reduced supply pushing prices up.

In the AD-AS diagram, this leftward shift in SRAS results in lower output but a higher price level.

Supply shocks can cause stagflation—a combination of high prices and low output—when negative.

Types of inflation: demand-pull and cost-push

Inflation is a sustained increase in the overall price level in an economy. In the AD-AS model, it can arise from shifts in either AD or SRAS, leading to two main types based on the cause.

Demand-pull inflation

Demand-pull inflation occurs when aggregate demand grows faster than the economy's ability to supply goods and services. This often stems from positive AD shocks.

Key features of demand-pull inflation:

• It pulls prices up as excessive demand competes for limited resources.
• Output and employment typically rise alongside the higher price level.
• In the AD-AS diagram, a rightward shift in AD increases both output and prices.

This type is common during economic booms when spending is high.

Cost-push inflation

Cost-push inflation happens when production costs rise, reducing short-run aggregate supply. This is linked to negative SRAS shocks.

Key features of cost-push inflation:

• It pushes prices up due to higher costs being passed on to consumers.
• Output and employment usually fall as firms cut back production.
• In the AD-AS diagram, a leftward shift in SRAS raises prices but lowers output.

This type often results from external factors like commodity price spikes, leading to challenging economic conditions.