Aggregate Supply-Aggregate Demand Model PDF

Preview

Summary

This is a brief summary of the AS-AD model of Macroeconomics...

Description

Introduction: The AS–AD or Aggregate Demand–Aggregate Supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply. It is based on the theory of John Maynard Keynes. As mentioned, the model is about the two most basic aspects of macroeconomics which are Aggregate Demand and Aggregate Supply. Aggregate Demand (AD) can be defined as the amount of goods and services in the economy that will be purchased at all possible price levels whereas Aggregate Supply (AS) is the total amount of goods and services in the economy available at all possible price levels. In an economy, as the prices of most goods and services change, the price level changes and individuals and businesses change how much they buy. The aggregate supply curve on a graph illustrates the relationship between prices and output supplied whereas the aggregate demand curve shows relationship between price and real GDP demanded. When Aggregate Demand (AD) and Aggregate Supply (AS) curves are put together, it shows the AS-AD equilibrium in the economy. In the figure 1, we can see that the intersection of the AS and AD 1 curves indicates an equilibrium price level of P 1 and an equilibrium real GDP of Q 1. Any shift in aggregate supply or aggregate demand has an impact on the real GDP and the price level.

Short-run macroeconomic equilibrium occurs when the quantity of GDP demanded equals the quantity supplied, which is where the AD and short-term AS i.e. SAS curves intersect. The price level adjusts itself to achieve the equilibrium. It is important to know that short-run equilibrium does not necessarily take place at full employment. Long-run macroeconomic equilibrium occurs when real GDP equals to the potential GDP of the economy so that the economy is on the long term AS curve i.e. LAS as shown in the figure 2.

The AS-AD framework illustrates the reaction of an economy to an increase in aggregate demand:   

In the short run, the AD curve shifts to the right and the equilibrium moves along the initial SAS curve. Real GDP increases and the price level rises. The money wage rate rises to reflect the higher prices, and the SAS curve shifts leftward, decreasing real GDP and further raising the price level. In the long run, the SAS curve shifts leftward enough so that real GDP returns to potential GDP. Further adjustments cease. Real GDP is at potential GDP, and the price level is permanently higher than before the increase in aggregate demand.

The AS-AD model also explains how the economy responds to a decrease in aggregate supply: 

The SAS curve shifts leftward, real GDP decreases and the price level rises.

The factors affecting AS and AD curves: There are multiple activities that can cause shifts in the AS and AD curves. The following are factors that can affect the Aggregate Supply:   

The increase in nominal wages shifts AS to the left because costs of production increases, which lowers profits. The increase in prices of other inputs into manufacturing of products also shifts AS to the left because production costs increase. For example, the rise in the price of oil or electricity would increase costs for producers and lower their profits (so they produce less). The usage of technology can shift the AS to the right because it increases the productivity; as a result firms can produce more output with the same amount of resources (increases in efficiency). An example could be computers.

The factors that can cause changes to the Aggregate Demand curve are as follows:   

An increase in the income of the citizens will encourage them to spend more; eventually causing a rightward shift. When there is an increase in the country’s exchange rates, the net exports decrease and aggregate expenditure also takes a dip resulting in shifting the AD curve to the left. Foreign income also has a significant impact on the aggregate demand. When foreign income increases, exports will increase causing the curve to shift to the right as a result of increased aggregate demand.

Conclusion: The AS-AD framework divides the economy into two parts – the ‘demand side’ and the ‘supply side’; and examines their interaction using accounting identities, equilibrium conditions and behavioral and institutional equations. The ‘demand side’ typically examines factors relating to the demand for goods and the demand and supply of assets. The ‘supply side’ typically examines factors relating to output and pricing decisions of producers, and factor markets. The framework ensures that neither demand nor supply side factors are overlooked in the analysis and that macroeconomic outcomes depend on the interaction between the different markets.

Reference: 1. Economics: Parkin M., Powell M., Matthews K. Economics (6th edition, 2005) 2. http://econport.gsu.edu/content/handbook/ADandS/AD/Shift.html 3. http://macroeconomicanalysis.com/macroeconomics-wikipedia/ad-as-model/...