Aggregate supply aggregate demand model

The aggregate supply aggregate demand (AS-AD) model is a foundational concept in macroeconomic models, providing a framework to analyze the short-run and long-run behavior of an economy. It illustrates the interplay between the total output that firms are willing and able to produce (aggregate supply) and the total quantity of goods and services that consumers, businesses, government, and foreign buyers are willing to purchase (aggregate demand) at various price levels. This model is essential for understanding key macroeconomic phenomena such as inflation, unemployment, and economic growth.

History and Origin

The conceptual foundations of the aggregate supply aggregate demand model emerged from the intellectual currents of the 20th century, particularly influenced by the work of British economist John Maynard Keynes. Prior to Keynes, classical economic thought, often summarized by Say's Law, posited that "supply creates its own demand," implying that overproduction and general gluts were temporary and self-correcting. However, the Great Depression of the 1930s challenged this view, leading Keynes to develop an alternative perspective that emphasized the crucial role of aggregate demand in determining economic output and employment.²³

Keynes's seminal work, The General Theory of Employment, Interest, and Money, published in 1936, laid the groundwork for understanding how inadequate aggregate demand could lead to prolonged periods of high unemployment and economic stagnation. While Keynes himself primarily used an expenditure-output model (known as the Keynesian cross) rather than an explicit AS-AD diagram, his theories on the instability of aggregate demand and the potential for a market economy to operate below its potential output were instrumental.²¹, ²² The formal aggregate supply aggregate demand model, as it is widely taught today, was developed and popularized around the 1950s, evolving to become a primary simplified representation of macroeconomic issues, especially as inflation became a significant concern in the 1970s.

Key Takeaways

• The aggregate supply aggregate demand model illustrates the equilibrium between total output produced and total spending in an economy at a given price level.
• It distinguishes between short-run aggregate supply (SRAS), which is upward-sloping due to sticky wages and prices, and long-run aggregate supply (LRAS), which is vertical at the potential output level.
• Shifts in either aggregate demand or aggregate supply curves can lead to changes in real GDP, unemployment, and inflation.
• The model helps economists analyze the impact of fiscal policy and monetary policy on an economy's output and price level.
• It provides a framework for understanding business cycle fluctuations, including periods of recession and inflationary pressures.

Interpreting the Aggregate Supply Aggregate Demand Model

The aggregate supply aggregate demand model is interpreted by observing the intersection of the aggregate demand (AD) curve and the aggregate supply (AS) curve. This intersection point represents the macroeconomic equilibrium, determining the equilibrium price level and the equilibrium level of real GDP in the economy.²⁰

The AD curve slopes downward, reflecting an inverse relationship between the price level and the quantity of aggregate demand. This is due to effects such as the real-balances effect (changes in purchasing power), the interest-rate effect (changes in borrowing costs influencing investment and consumption), and the foreign purchases effect (impact on net exports).¹⁹ The short-run aggregate supply (SRAS) curve is typically upward-sloping, indicating that as the price level rises, firms are willing to produce more output in the short run because input prices (like wages) are sticky and do not immediately adjust.¹⁸ In contrast, the long-run aggregate supply (LRAS) curve is vertical at the economy's potential output, representing the full employment level of real GDP that an economy can achieve when all resources are fully utilized.¹⁷

Interpreting the model involves analyzing shifts in these curves. For example, a rightward shift of the AD curve can indicate an increase in overall spending, potentially leading to higher real GDP and a higher price level, suggesting demand-pull inflation.¹⁶ Conversely, a leftward shift of the SRAS curve, often caused by negative supply shocks (e.g., a sudden increase in the price of raw materials), can lead to lower output and a higher price level, a situation known as stagflation.¹⁴, ¹⁵ The position of the short-run equilibrium relative to the LRAS curve indicates whether the economy is experiencing a recessionary gap (output below potential GDP, implying high unemployment) or an inflationary gap (output above potential GDP, indicating pressures for higher inflation).¹², ¹³

Hypothetical Example

Consider the hypothetical economy of "Prosperity Peak." Initially, Prosperity Peak is at long-run macroeconomic equilibrium, with a stable price level and real GDP at its potential output.

Scenario: Suppose the government of Prosperity Peak implements a significant increase in government spending as part of an expansionary fiscal policy.

Step-by-step analysis using the AS-AD model:

1. Initial Equilibrium: The AD, SRAS, and LRAS curves intersect at a single point, representing the economy's long-run equilibrium with full employment and stable prices. The horizontal axis represents [real GDP], and the vertical axis represents the [price level].
2. Shift in Aggregate Demand: The increase in government spending directly boosts one component of [aggregate demand]. This causes the aggregate demand (AD) curve to shift to the right.
3. Short-Run Impact: In the short run, with the SRAS curve being upward-sloping, the new intersection point between the shifted AD curve and the original SRAS curve will be at a higher real GDP and a higher price level. This indicates that the economy experiences increased output and a higher rate of [inflation] in the short run. The higher output might lead to lower [unemployment].
4. Long-Run Adjustment: Over time, as the economy operates beyond its potential output, resource prices, including wages, will begin to rise in response to increased demand. This causes the short-run aggregate supply (SRAS) curve to shift to the left.
5. New Long-Run Equilibrium: The SRAS curve continues to shift left until the economy returns to its potential output level, where the new, shifted AD curve intersects the new SRAS curve at the original potential output but at an even higher price level. In the long run, the expansionary fiscal policy primarily results in a higher price level with no sustained change in real GDP.

This example demonstrates how the aggregate supply aggregate demand model can illustrate both the short-run impacts and long-run adjustments of economic policy on the economy's output and price level.

Practical Applications

The aggregate supply aggregate demand model is a versatile tool widely employed by policymakers, economists, and analysts to understand and predict macroeconomic trends. It provides a visual and conceptual framework for analyzing the effects of various economic events and policy decisions on an economy's output, employment, and price level.¹¹

• Monetary Policy Analysis: Central banks, such as the Federal Reserve, frequently use the AS-AD model to evaluate the potential impact of their monetary policy decisions. For instance, if the Federal Reserve implements expansionary monetary policy by lowering [interest rates] or increasing the money supply, it can stimulate [investment] and [consumption], leading to a rightward shift in the aggregate demand curve. This helps combat a [recession] by increasing real GDP and reducing [unemployment], though it may also lead to higher inflation.¹⁰ Conversely, contractionary monetary policy aims to reduce aggregate demand to combat high inflation.
• Fiscal Policy Analysis: Governments use the AS-AD model to analyze the effects of [fiscal policy] changes, such as adjustments in government spending or taxes. Increased government spending or tax cuts are expansionary fiscal policies that shift the aggregate demand curve to the right, aiming to boost economic activity.⁹ The model helps predict the resulting changes in output and the price level.
• Understanding Business Cycles: The model is crucial for visualizing the phases of the [business cycle]. A decline in aggregate demand can lead to a recessionary gap, characterized by lower real GDP and higher unemployment. Conversely, strong aggregate demand exceeding potential output can create an inflationary gap.⁸
• Supply-Side Economics: The model also allows for the analysis of supply-side policies, which aim to shift the aggregate supply curve. Policies that reduce business taxes, decrease regulatory burdens, or improve productivity can lead to a rightward shift in aggregate supply, resulting in higher output and a lower price level, promoting non-inflationary [economic growth].⁶, ⁷

Understanding these interactions is vital for policy formulation, as seen in the ongoing discussions surrounding economic stabilization and growth strategies by institutions like the Federal Reserve.⁵

Limitations and Criticisms

While the aggregate supply aggregate demand model is a widely used pedagogical and analytical tool in [macroeconomics], it also faces several limitations and criticisms. One significant critique revolves around its logical consistency, particularly regarding the short-run aggregate supply curve. Some economists argue that the assumptions underlying the aggregate demand curve (e.g., that higher prices reduce real balances, leading to lower investment and consumption) can conflict with the assumptions for the upward-sloping short-run aggregate supply curve, which often assumes sticky wages and prices that don't immediately adjust to price level changes.⁴

Another criticism centers on the practical definition and measurement of aggregate demand itself. Economists may disagree on whether nominal GDP or real GDP is the best proxy for [aggregate demand], leading to debates that can sometimes appear to be over semantics rather than fundamental economic realities. This divergence in definition can make it challenging to agree on whether aggregate demand has actually increased in real-world scenarios, hindering consensus on policy responses.³

Furthermore, the static nature of the traditional aggregate supply aggregate demand model is a simplification. The economy is dynamic, with continuous changes in output and the [price level], or more accurately, the rate of [inflation]. Modern macroeconomic models often use dynamic versions of the AS-AD framework that incorporate inflation rates and monetary policy rules, such as the Taylor rule, to better reflect real-world policy discussions. Critics also point out that the model, especially in its basic form, may not fully capture complex real-world phenomena like the "bankruptcy effect" of deflation, where falling prices can further reduce [aggregate demand] by increasing the real burden of debt.²

The model's reliance on specific assumptions about wage and price stickiness in the short run and full flexibility in the long run can also be seen as a simplification that may not always hold true in diverse economic contexts. Despite these criticisms, the aggregate supply aggregate demand model remains an important starting point for understanding fundamental macroeconomic relationships.

Aggregate Supply Aggregate Demand Model vs. IS-LM Model

The aggregate supply aggregate demand model and the [IS-LM model] are both foundational tools in macroeconomics, but they serve different purposes and operate at different levels of aggregation.

The IS-LM model focuses on the interaction between the goods market (Investment-Savings, IS curve) and the money market (Liquidity Preference-Money Supply, LM curve) to determine the equilibrium interest rate and output level, assuming a fixed price level.¹ In essence, the IS-LM model can be viewed as a building block for the aggregate demand curve. Changes in the equilibrium from the IS-LM model (e.g., due to fiscal policy or monetary policy) can be used to derive shifts in the aggregate demand curve within the AS-AD framework. Thus, while the AS-AD model provides a broader picture of the economy's output and price level, the IS-LM model offers a more detailed look at the mechanisms through which [interest rates] and aggregate expenditures influence aggregate demand.

FAQs

What does the aggregate supply aggregate demand model illustrate?

The aggregate supply aggregate demand model illustrates the interaction between the total supply of goods and services produced in an economy (aggregate supply) and the total demand for those goods and services (aggregate demand), at various price levels. It helps determine the equilibrium level of national output (real GDP) and the overall price level, shedding light on issues like [inflation] and [unemployment].

How do government policies affect the AS-AD model?

Government policies, both [fiscal policy] (changes in government spending and taxes) and [monetary policy] (actions by the central bank affecting interest rates and the money supply), can shift the aggregate demand or aggregate supply curves. Expansionary policies typically shift aggregate demand to the right, aiming to increase [real GDP] and reduce unemployment, while contractionary policies shift it to the left to combat inflation. Supply-side policies can shift the aggregate supply curve.

What is the difference between short-run and long-run aggregate supply?

In the short run, the [short-run aggregate supply] (SRAS) curve is typically upward-sloping because some input prices, like wages, are "sticky" and don't immediately adjust to changes in the [price level]. This means firms can temporarily increase output as prices rise, leading to higher profits. In the long run, however, all prices and wages are assumed to be fully flexible and adjust to the price level. The [long-run aggregate supply] (LRAS) curve is vertical at the economy's potential output, representing the maximum sustainable output when all resources are fully employed, regardless of the price level.

Can the AS-AD model predict recessions?

The AS-AD model can illustrate the conditions that lead to or characterize a [recession]. A recessionary gap occurs when the equilibrium level of [real GDP] is below the economy's potential output, often due to a significant decrease in [aggregate demand]. The model shows that this situation is associated with high [unemployment]. While it illustrates the state of a recession, it doesn't predict their precise timing or duration independently.