Economics : AD-AS model

AD-AS model

Aggregate output of an economy is the total value of output at constant market prices, so it’s measured by the real GDP = C + I + G + NX

Aggregate demand (AD) = the relationship of aggregate quantity demanded AQ_d against different price level P. It’s downward slopping due to three reasons:

1)       Wealth effect: P↑→Real wealth of people↓→C↓→AQ_d↓

2)       Interest rate effect: P↑→People tends to save less and more borrowing (since cost of living↑)→i_r↑→C, I↓→AQ_d↓

3)       Foreign price (real exchange rate) effect: P↑→Local good becomes relatively more expansive than foreign goods→NX↓→AQ_d↓

Same as the D-S model, change in price level does not change the AD but AQ_d only.

Change in AD is related with:

1)       C: economic prospects, disposable income, tax/allowances, i% and saving habits

2)       I: i%, economic prospects, (profit) tax rates and technological level

3)       G: government revenue and expenditure

4)       NX: foreign price level, exchange rates and trading policies

Aggregate supply is the relationship between aggregate quantity supplied AQ_s against the price level. There’re two types of AS: short and long run.

Short run: the period that producers haven’t fully recognized and make adjustments to the change in economic conditions. This is due to imperfect market information and high adjustment cost (e.g. the signed contract)

Long run: the period that producers have fully recognized and make adjustments.

SRAS is upward slopping because:

1)       Sticky-cost (wage) effect: The input prices are usually fixed during a short period under the same contract. When P↑, output price rises more than input prices, so it’s more profitable to produce more, so AQ_s↑.

2)       Misperception effect: When P↑, it’s considered as rising of real income instead of nominal income, so it produces more and AQ_s↑.

LRAS is a vertical line at the full-employed output (Y_f) since there’s no sticky-cost and misperception effect. When cost and price is completely flexible, the aggregate output stays at Y_f as it is the maximum sustainable output in the economy. The production decisions are not affected by the change in P, so it’s vertical at Y_f, and is independent of P.

-          Y_f is not the maximum possible output, but the economy is not sustainable beyond Y_f (for example, workers works OT, but this is not sustainable as their body is damaged), and the resources are not fully utilized before Y_f.

-          Practically SRAS is relatively gentle before Y_f and steep beyond it because extracting unused resources (like reliving unemployment) is easier than extracting resources from a fully utilized economy.

Change in SRAS:

1)       MC of (all) firms ↑/↓→supply price per good ↑/↓→SRAS↓/↑

2)       Expecting (not actual) ↑/↓ in price level → workers’ misperception in ↓/↑ of their real wages and producers’ misperception in ↓/↑ of their revenue → ↓/↑ their production → SRAS ↓/↑

3)       Supply shock about factors of production (e.g. labour strike and transportation delay)

4)       (Indirect) tax / subsidies → SRAS ↓/↑

LRAS is only affected by the quality or quantity of factors of production.

Short-run equilibrium: In short run the equilibrium AQ and P is decided by the intersection between AD and SRAS, where AQ_d=AQ_s.

Long-run equilibrium: In long run the equilibrium AQ and P is decided by the intersection between AD and LRAS, where Y_d = Y_f, independent of P.

Similar to D-S model, surplus (AQ_s > AQ_d) decreases P until P_e and in shortage (AQ_s < AQ_d) increases P until P_e, so the equilibrium is reached.

Inflationary and deflationary output gap

These case occurs when short-run equilibrium and long-run equilibrium does not intersect at the same point.

For deflationary output gap, AQ_SR < Y_r, it follows that not all resources are utilized, then there’s unemployment in factors of production, then MC of those factor decreases, causing SRAS shift to the right until short and long run equilibrium is attained at the same time. In this case,  P↓ and Y↑.

For inflationary output gap, AQ_SR > Y_f, then there’s shortage in factors of production, causing MC of factors of production increase, so SRAS shift to the left until short and long run equilibrium is attained at the same time. In this case,  P↑ and Y↓.

Change in AD

AD↑/↓ → inflationary/deflationary gap occurs → P and AD ↑/↓ in SR → in LR SRAS ↓/↑ → P↑/↓ and AD back to Y_f.

In overall a two-step inflation/deflation occur and the AD changes and back to Y_f

Change in AS:

When AS shifts, in short-run, inflationary (SRAS↑) or deflationary (SRAS↓) output gap appears. In long run, the SRAS shifts back to its original places. In short run, P↓(SRAS↑) or P↑ (SRAS↓) and Y_e↑(SRAS↑) or Y_e↓(SRAS↓).

In some cases more than one curve is shifted. For example, importing talents may increase AD (consumption) and LRAS (quality and quantity of labour).

Consider the LR equilibrium, if AD increases, there’s a increase in P. If LRAS increases, Y increases while P decreases. Under the assumption of parallel shift, the curve with larger shift dominants the net effect in P and Y.

For example, when AD and LRAS increases:

1)       AD↑ > LRAS↑: P↑ and Y↑

2)       AD↑ = LRAS↑: P is unchanged and Y↑

3)       AD↑ < LRAS↑: P↓ and Y↑

For more complicated case (all 3 curves is moved at the same time), their short run effect is sometimes uncertain because the magnitude of shifting in a definite time in short run is unknown. Consider this example:

“A lot of foreign labour left a economy. If the shift of LRAS = shift of AD, find the change in P and Y in short and long run.

Long run: consider the long-run equilibrium, since the shift of LRAS and AD is equal, so P is unchanged while Y is decreased.

Short run: Y decreases, but P is uncertain as it can be any point in the rhombus.