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## Macroeconomics

### Course: Macroeconomics>Unit 3

Lesson 6: Changes in the AD-AS model in the short run

# How the AD/AS model incorporates growth, unemployment, and inflation

## Key points

• The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.
• We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram.
• Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP.
• The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram.
• Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

## The AD/AS model allows economists to analyze multiple economic factors.

Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts including the three macroeconomic goals of growth, low inflation, and low unemployment; the elements of aggregate demand; aggregate supply; and a wide array of economic events and policy decisions.
The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing these factors together in one diagram. In addition, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach—focusing on aggregate demand and the short run—while also including the Say’s law approach—focusing on aggregate supply and the long run.

## Growth and recession in the AD/AS model

We can examine both long-term and short-term changes in gross domestic product, or GDP, using the AD/AS model. In an AD/AS diagram, long-run economic growth due to productivity increases over time is represented by a gradual rightward shift of aggregate supply. The vertical line representing potential GDP—the full-employment level of gross domestic product—gradually shifts to the right over time as well. You can see this effect in AD/AS diagram A below, which shows a pattern of economic growth over three years.
However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in an AD/AS diagram.
AD/AS diagram A, on the left, shows how productivity increases will shift aggregate supply to the right.
Image credit: Figure 1 in "Shifts in Aggregate Supply" by OpenStaxCollege, CC BY 4.0
In the short run, GDP, falls and rises in every economy as the economy dips into recession or expands out of recession. When an AD/AS diagram shows an equilibrium level of real GDP substantially below potential GDP—as is shown in the diagram below at equilibrium point start text, E, 0, end text—it indicates a recession. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP—as it is at equilibrium point start text, E, 1, end text.
The higher of the two aggregate demand curves in this AD/AS diagram is closer to the vertical potential GDP line and hence represents an economy with a low unemployment. In contrast, the lower aggregate demand curve is much farther from the potential GDP line and hence represents an economy that may be struggling with a recession.
Image credit: Figure 2 in "Shifts in Aggregate Demand" by OpenStaxCollege, CC BY 4.0

## Unemployment in the AD/AS diagram

We can examine two different types of unemployment using an AD/AS diagram—cyclical unemployment and the natural rate of unemployment. Cyclical unemployment bounces up and down according to the short-run movements of GDP. The long-term, baseline level of unemployment that occurs year in and year out, however, is called the natural rate of unemployment.
The natural rate of unemployment is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.
In an AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full-employment level of GDP. Take another look at the AD/AS diagram above. Relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as at the equilibrium point start text, E, 1, end text. On the other hand, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point start text, E, 0, end text.
The factors that determine the natural rate of unemployment are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP, or full-employment GDP, in a given economy.

## Inflationary pressures in the AD/AS diagram

Inflation fluctuates in the short run, and higher inflation rates typically occur either during or just after economic booms. For example, the biggest spurts of inflation in the US economy during the 20th century followed the wartime booms of World War I and World War II. On the other hand, rates of inflation generally decline during recessions.
The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the aggregate supply curve. Let's look at diagram A, on the left below. In this diagram, you'll see a shift of aggregate demand to the right. The new equilibrium start text, E, 1, end text is at a higher price level than the original equilibrium start text, E, 0, end text. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.
The two graphs show how a shift in aggregate demand or supply can cause inflationary pressure. The graph on the left shows two aggregate demand curves to represent a shift to the right. The graph on the right shows two aggregate supply curves to represent a shift to the left.
Another source of inflationary pressures is a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor. This situation can cause the aggregate supply curve to shift back to the left. In diagram B above, the shift of the SRAS curve to the left also increases the price level from start text, P, 0, end text at the original equilibrium start text, E, 0, end text to a higher price level of start text, P, 1, end text at the new equilibrium start text, E, 1, end text. In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.
An AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years.

## Summary

• The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.
• We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram.
• Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP.
• The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram.
• Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

## Self-check questions

What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model?
Suppose, after five years of sluggish growth, the economy of the European Union picks up speed. What would be the likely impact on the US trade balance, GDP, and employment?
Suppose the Federal Reserve begins to increase the supply of money at an increasing rate. What impact would that have on GDP, unemployment, and inflation?

## Review questions

• How is long-term growth illustrated in an AD/AS model?
• How is recession illustrated in an AD/AS model?
• How is cyclical unemployment illustrated in an AD/AS model?
• How is the natural rate of unemployment illustrated in an AD/AS model?
• How is pressure for inflationary price increases shown in an AD/AS model?

## Critical thinking questions

• If foreign wealth holders decided that the United States was the safest place to invest their savings, what would the effect be on the economy here? Show graphically using the AD/AS model.
• The AD/AS model is static. It shows a snapshot of the economy at a given point in time. Both economic growth and inflation are dynamic phenomena. Suppose economic growth is 3% per year and aggregate demand is growing at the same rate. What does the AD/AS model show the inflation rate should be?

## Want to join the conversation?

• I just wondered can the impacts of covid-19 shift the long run AS to the left?
• Actually, in the short term, this displacement could already be seen, productivity fell in an extreme way (you can see that with the fall in the price of the shares of all companies or the increase in their debt) and in the long term (we hope that no) the economy is going to hell and only the tech sector will survive
• Self check-question 3
If fed is raising interest rates than people will put their money in the banks and industries will have to pay higher interest rates for the loans then it should reduce the aggregate demand and GDP?
• The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP
what does it mean? potential GDP is the point where every labor force is employed, isn't it?
• full employment is a situation in which all available labor resources are being used in the most economically efficient way. ... Deficient-demand unemployment is similar to cyclical unemployment in that it arises when there isn't enough aggregate demand in an economy to support full employment.
• Covid-19 cases are up roaring now, as. now in the US it is 12.8 million cases with 262k deaths :(.
• What does a recession mean for our economy using different models in Macroeconomics? What are the adjustments and factors affected? Also, how will increasing Government spending and increasing taxes affect those models and get the economy out of a recession?
(1 vote)
• Recession to an economy means that the economy is not functioning to its full potential.
The current levels of GDP are less than Potential GDP from the AD-AS curve in an economy which is in the recessionary phase.
Increase in Government Spending(increase in G) and decreasing the tax encourage people to consume more and businesses to invest more, which will push the AD curve towards the right(as C and I increase which eventually decrease the trade deficit). This is often referred to as expansionary Fiscal Policy and is employed to bring the economy out of Recessionary Gap.
(1 vote)
• Why aggregate demand does not increase for the same reason in response to a decrease in the aggregate price level ? In other words, what causes total spending to increase if it not because goods are now cheaper?
(1 vote)
• aggregate demand would increase because there has have a lot of goods and services being produced , so there would be a lot of spending increasing because of the goods that are being sold
(1 vote)
• In my economics class today, we talked about the inflationary gap caused due to excess demand. The government, in order to reduce inflation, invests in administration and civil service. How does this help to reduce inflation? Need your help Khan Academy!
• Just understand it this way. Any economy running in Inflationary phase is not sustainable(As people are made to work beyond their capacity and many such reasons).
Also, note that in the long run, any increase in the AD will not impact GDP much and only increase the price levels thus causing the Inflation.So to bring back the economy to the levels of potential GDP govt employs the Fiscal policy tools i.e Tax cuts and reduced govt spending.Instead, G is diverted towards administration and civil services(as they don't contribute to GDP).When G is decreased and Taxes are increased, C decreases, I component decreases and thus AD decreases bringing down the price levels and equilibrium GDP
• To discuss the critial thinking questions:

- If foreign wealth holders decided that the United States was the safest place to invest their savings, then the GDP of the united states would increase as there would be an increase in investment and lending. AS would shift to the right.

- If economic growth is 3% per year and aggregate demand is growing at the same rate, then there should be no inflation since both the AD and AS curve shift together to the right.

I hope that the answers make sense! Thoughts?
• - I think an increase in investment will directly affect AD, causing it to shift to the right and thereby leading to demand-pull inflation. This will cause the quantity of AS to increase and will result in an increase in real GDP.

- I think the same.
(1 vote)
• Draw a graph showing Aggregate Demand and Aggregate Supply under assumption that you are an economist who views the AS curve as vertical and that changes in Real GDP only come from the supply side economy. Then, explain what the impact of fiscal policy aimed at aggregate demand would do.