The AD-AS Model

Aggregate demand shows the relationship between aggregate output and the price level in the simultaneous equilibrium of goods and money markets. An individual market demand curve shows the relationship between the quantity demanded for a particular good at that good’s particular market price, and the demand behavior is given by consumer preferences. Aggregate demand relationship on the other hand, considers the relationship between the general level of prices, such as the consumer price index or the GDP deflator, and the real GDP in an economy.

In deriving the AD-curve, we hold the exogenous factors such as government policy or autonomous behavior of agents fixed. That is, along a given AD-curve, government spending, net taxes, nominal money supply, autonomous consumption and autonomous investment spending are fixed. AD-curve may shift due to exogenous factors such as demand-side policy changes (monetary and fiscal policies) or other autonomous factors affecting demand, such as autonomous consumption or investment.

A movement along a given AD-curve is caused only by changes in the price level. A change in any one of the exogenous factors (other than the price level) will cause a shift of the AD curve.

Expansionary fiscal and monetary policies cause the AD-curve to shift up and to the right. For example an increase in government spending, a decrease in net taxes (an increase in transfers, a decrease in taxes collected) and an increase in nominal money supply caused by an open market purchase, a decrease in the required reserve ratio, a decrease in discount rate.

Contractionary fiscal and monetary policies cause the AD-curve to shift down and to the left. For example a decrease in government spending, an increase in net taxes (a decrease in transfers, an increase in taxes collected) and a decrease in nominal money supply caused by an open market sale, an increase in the required reserve ratio, an increase in discount rate.

The Aggregate Supply curve shows how the general level of prices respond to changes in aggregate output or the GDP. The Aggregate Supply curve is not simply the horizontal summation of all the sectors’ output at every price level, rather, it shows how the general level of prices respond to changes in GDP, given the behavior of all actors, such as the employees or workers and the employers or the firms, and the condition of pricing institutions in an economy.

In economic theory, the shape of the aggregate supply curve depends on the time frame during which prices may be fixed or flexible. In the short-run, since prices are sticky at predetermined levels, the aggregate supply curve is horizontal, and prices do not respond to changes in the GDP. In the long-run on the other hand, prices are fully flexible, the level of aggregate output is only determined by the amount of capital and labor and the technology by which they are combined, and the same output will be produced regardless of the price level. These are the two extreme views on the aggregate supply relationship.

The SRAS is also called the Keynesian Aggregate Supply curve and it is horizontal, implying that at the existing price level, firms are willing to supply whatever amount of goods is demanded in the economy. This implies that there is ongoing unemployment in the economy, such that firms can hire as much labor as they want and increase production at the current wage without raising the prices. Firms are willing to supply as much output as demanded in the economy at the existing price level. Another justification for the horizontal aggregate supply curve is that in the short-run, some prices are sticky, and prices do not adjust to changes in demand. In the short-run, firms may find it costly to change prices (issue new restaurant menus, or issue new catalogs with new prices), and hence prices will be stuck at predetermined prices even if the demand conditions change in the short-run. In that sense, the firms will be willing to produce and sell as much as the customers demand, and hire workers to produce just the amount demanded without raising prices.

LRAS, or the Classical Aggregate Supply curve is vertical, indicating that the same amount will be supplied regardless of the price level in the economy. The Classical Aggregate Supply assumes that the economy is at full employment producing the potential output of the economy, Y* (the output that the economy produces under full employment of labor is called the potential output or the natural output level).

Potential output depends on the fixed amounts of available factors, labor, capital and land and available technology by which these factors of production is combined, and hence will change only if resources accumulate over time and/or if production technology changes. The rightward shift of the vertical LRAS curve corresponds to the growth of potential GDP via growth in factors and/or technological improvements, including institutional changes.

In the long-run, changes in the aggregate demand have no effect of output, rather, the change in the aggregate demand will only create a proportional change in the price level when prices are fully flexible. For example, if nominal money supply increases, this will only create a proportional increase in the price level with no change in potential output, because potential output does not respond to changes in AD, and changes only if the given amounts of factors and/or available technology change.  This phenomenon is called as neutrality of money.

There are many alternative theories as to why prices and wages are sticky in the short-run. These theories are monopolistic competition, menu costs, imperfect ınformation, contracts and long-term relationships, insider-outsider models and efficiency wages model.

There is a positive relationship between price and output level. This positive relationship summarizes a trade-off in the short-run: A higher output is only possible via increasing prices, that is, in order to reduce unemployment and increase output, the economic actors must accept a higher price level.

The increase in price expectations  would lead to an upward shift in the AS-curve. An exogenous increase in price expectations would lead to an exogenous increase in wages, at the given unemployment rate and at constant z. This exogenous increase in wages would prompt an exogenous increase in the price level, at the given output level. This implies a vertical upward shift in the AS-curve. Other factors that may lead to a shift in the AS-curve are the changes in the parameters z and μ which we hold fixed along a given AS-curve.

The economy is producing above the potential output level, hence the actual unemployment rate is very low and below the natural unemployment rate, and the actual price level in the economy is higher than the expected price written into existing wage contracts. This is a short-run equilibrium because the current situation is temporary and will not last for too long, the equilibrium will change once the new wage contracts are negotiated with a higher expected price. This is why this gap is called an inflationary gap because eventually a rise in the price level ensues this short-run equilibrium.

It is said that an economy is in a recessionary gap when it is producing below the potential output, has a high unemployment rate above the natural unemployment rate, and currently the actual price level is below the expected price written into the current wage contracts. Again, this situation is temporary as new wage contracts will be negotiated over time with a lower expected price, and the actual price level will fall in the process.

Neutrality of money means that in the medium-run (and also in the long-run), a monetary policy change has no effect on the economy’s real variables, such as employment, real wage and output; the only effect is on another nominal variable, the price level.

Any change in the economy that causes an exogenous change in the production process can be considered an aggregate supply shock. This change can stem directly from a change in technology, capital stock, the population, or input prices other than labor such as oil or energy. Changes in the production process can also be due to changes in labor market laws or competition laws. Such changes will be considered institutional changes. Holding all else constant, all of these factors mentioned may lead to a change in the economy’s natural rate of unemployment and thus a change in the potential output or natural level of output.

Stagflation is a word that combines two words: Stagnation and inflation. Stagflation is an economic phenomenon when the economy experiences significant inflation together with high unemployment, little or no growth in real GDP.

Supply side shocks, such as shocks to non-labor cost factors like energy prices, shocks in the labor market like minimum wage changes, or institutional shocks such as changes in competition law will lead to changes in the labor market equilibrium, the equilibrium real wage, the natural rate of unemployment, and thus the potential output. In the short-run, the immediate effect will be a change in aggregate supply and the price level, but in the medium-run, the potential output of the economy will change. Negative supply-side shocks such as an increase in energy prices will cause “stagflation”, where the economy experiences a decrease in the potential output along with an increase in the price level.