Mastering the AS-AD Model: Navigating Equilibrium and Shifts
4/22/2024 Jacob Reed
Now that you have already learned about the Aggregate Demand as well as Short-run and Long-run Aggregate Supply, we are now going to combine them in the AS/AD model. The AS/AD model of the economy shows there the macro economy is as it relates to our 3 economic goals of full employment, stable prices, and economic growth.
The Graph
The x-axis on the AS/AD model graph is labeled real GDP (rGDP). Real GDP is also called real output or national income (abbreviated as Y). The x-axis also correlates with employment. So, when real output is high, employment is also high, which means unemployment is low, and when real output is low, employment is also low, which means unemployment is high. The y-axis on the AS/AD model is labeled Price Level (PL).
The first curve on the graph is aggregate demand (AD). It is downward sloping and shows the inverse relationship between the price level and the quantity of real GDP demanded throughout the entire economy. AD shifts from changes in the components of the output expenditure formula for GDP (C+Ig+G+Xn).
There are two different aggregate supply curves. The short-run aggregate supply curve (SRAS) is upward sloping and shows the direct relationship between the price level and the quantity of real GDP output. The SRAS shifts from changes in input prices, productivity, regulation, and taxes on businesses. The long-run aggregate supply curve (LRAS) is vertical at the quantity of real GDP that correlates to the full employment (zero cyclical unemployment) level of real output (Yf on the graph).
Short-run Aggregate Equilibrium
Just like supply and demand graphs, economic forces push the economy toward equilibrium. The short-run equilibrium is always found at the intersection of the aggregate demand and short-run aggregate supply. At that intersection we, find the economy’s equilibrium price level and real GDP output. If the price level is above equilibrium, there will be an aggregate surplus and the price level will eventually fall to equilibrium. If the price level is below equilibrium, there will be an aggregate shortage and the price level will eventually rise to equilibrium. Unless otherwise specified, you can assume on your exams, that economies are in short-run equilibrium.
There are 3 types of short-run equilibrium, and they all have to do with the relationship between the current real GDP equilibrium output (Ye) and the full employment level of output (Yf). When Ye is less than Yf, the economy has a recessionary gap. That means the current output is less than the long-run potential output and unemployment will be higher than the natural rate of unemployment.
The second type of short-run equilibrium occurs when Ye is greater than Yf. That’s when the economy has an inflationary gap. Current output will be more than long-run potential output, and the unemployment rate will be lower than the natural rate.
The last short-run equilibrium occurs when Ye is equal to Yf. Here, all 3 curves intersect, current output equals long-run potential output and the unemployment rate equals the natural rate of unemployment. When there is not gap between potential and actual real GDP, we call this long-run equilibrium; because this is where we expect the economy to be in the long-run.
Changes in Equilibrium
If either the aggregate demand or short-run aggregate supply shifts, that will change the equilibrium price level and equilibrium real GDP.
When there is a shift of aggregate demand, the price level and real GDP will go in the same direction. If the aggregate demand increases (shifts to the right), the price level will increase, and real GDP will also increase. Since real output increases, means unemployment decreases. If aggregate demand decreases (shifts to the left), the price level will decrease, and real GDP will decrease as well. The lower real output will cause unemployment to increase.
When the short-run aggregate supply curve shifts, the price level and real GDP will go in opposite directions. If short-run aggregate supply increases (shift to the right), the price level will decrease, and real GDP will increase, causing unemployment to fall. If short-run aggregate supply decreases (shifts to the left), the price level will increase, and real GDP will decrease, causing unemployment to rise.
Note: You could see questions that deal with multiple shifts. When that occurs, graph out both shifts and see what happened on axes of the graph. If both shifts are in agreement (like both shifts increase the price level), then that change is definite (the price level will increase). If both shifts are in conflict (one shift increase the price level, while the other decreases the price level), then that change is indeterminate.