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 demand or supply can affect output, employment, and prices over time.

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 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, considering sticky wages and prices. It slopes upward as higher prices encourage more production.
• Long-run aggregate supply (LRAS) - The total supply of goods and services at full employment, where resources are fully utilized. It is vertical because, in the long run, output depends on factors like technology and labor, not price levels.

This model illustrates equilibrium where AD intersects with SRAS and LRAS, determining the economy's output and price level. Shocks can disrupt this balance, but the economy tends to self-adjust over time.

How the economy self-adjusts in the long run after shocks

In the long run, an economy can return to full employment without government intervention through adjustments in wages and prices. Full employment occurs when all available resources are used efficiently, and unemployment is at its natural rate—the level that includes frictional and structural unemployment but not cyclical unemployment.

The process of long-run self-adjustment

Flexible wages and prices play a key role in this adjustment. When a shock occurs, it may create a gap between actual output and potential output (the level at full employment).

Over time:

• If output is below potential, high unemployment leads to lower wages, reducing production costs. This shifts SRAS rightward, increasing output and lowering prices until full employment is restored.
• If output is above potential, low unemployment drives wages up, increasing costs. This shifts SRAS leftward, decreasing output and raising prices back to equilibrium.

As a result, the economy reverts to the natural rate of unemployment, and output returns to the level shown by LRAS.

Responses to aggregate demand and aggregate supply shocks

Shocks are unexpected events that shift AD or SRAS, affecting output, employment, and prices. In the long run, the economy adjusts differently depending on the type of shock, restoring balance through wage and price flexibility.

Response to an aggregate demand shock

An aggregate demand shock changes total spending in the economy, such as a sudden increase in consumer confidence (positive shock) or a financial crisis (negative shock).

• Positive AD shock - AD shifts right, raising output and prices in the short run. This creates inflationary pressure and low unemployment, pushing wages up. SRAS then shifts left, increasing prices further but reducing output back to full employment.
• Negative AD shock - AD shifts left, lowering output and prices. High unemployment causes wages to fall, shifting SRAS right and restoring output to potential while prices stabilize.

In both cases, long-run equilibrium returns at the original LRAS, with prices adjusted but output at full employment.

Response to a short-run aggregate supply shock

A short-run aggregate supply shock affects production costs, like an oil price spike (negative shock) or a technological improvement (positive shock).

• Negative SRAS shock - SRAS shifts left, raising prices and reducing output (stagflation). High unemployment leads to wage decreases, gradually shifting SRAS back right to restore full employment and lower prices.
• Positive SRAS shock - SRAS shifts right, lowering prices and increasing output. Low unemployment raises wages, shifting SRAS left to return output to potential while prices rise slightly.

The long-run outcome is equilibrium at LRAS, with the economy self-correcting through flexible wages and prices.

Comparing long-run responses to shocks

These adjustments ensure the economy returns to full employment without policy actions.

The role of long-run aggregate supply shifts in economic growth

Shifts in the long-run aggregate supply curve represent changes in an economy's productive capacity, which directly relate to economic growth—the sustained increase in potential output over time.

Causes and effects of LRAS shifts

• Rightward shift in LRAS - Indicates growth, often from improvements in technology, increases in labor force, or better education. This raises full-employment output, allowing higher production without inflation.
• Leftward shift in LRAS - Signals a decline in potential output, possibly due to resource depletion or population decrease. This reduces the economy's capacity, leading to lower growth.

Such shifts affect the full-employment level of output, influencing long-term living standards and employment opportunities. For example, investing in infrastructure can shift LRAS right, promoting sustainable growth.