AD AS Model

When you go to a gas station to put gasoline in your car and you notice that, due to a global event decreasing the availability of oil, the price of gasoline is going up, do you behave differently? Do you buy fewer gallons of gas? What else in our economy is affected by the global increase in oil prices?

If the FED decides to decrease the interest rate, is that a good thing or a bad thing?

Why do prices rise when employees become less productive?

You can answer all these questions and more using the AD-AS model. This article will help you learn everything you need to know about the AD-AS model.

What is AD-AS Model?

AD-AS model is a model in which all goods and services of an economy are modeled as one marketplace, with an aggregate demand curve and an aggregate supply curve.

During the 1970s, the aggregate supply curve shifted to the left, increasing the aggregate price level in the US economy. On the other hand, when the 2008 financial crisis hit the economy of the United States, the aggregate demand shifted to the left, causing a decrease in the level of output associated with a fall in price levels.

There can many periods in which an economy deviates from its equilibrium level of output. Many factors could cause an economy to temporarily shift from its equilibrium output—however, one common thing for all these fluctuations is in either the aggregate demand or aggregate supply curve.

AD-AS Model Definition

AD-AS Model Graph

Figure 1 illustrates the AD-AS model. In this graph, notice three important curves: Aggregate demand (AD), Short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS).

Fig. 1 - AD-AS model graph

Aggregate demand refers to the total demand for goods and services within the economy. It consists of consumption, investment, government spending, and net exports. For more details on aggregate demand, check our explanation.

As the name suggests, short-run aggregate supply (SRAS) refers to the supply of companies in the short run.

Long-run aggregate supply (LRAS) refers to the full employment level of real output, the total amount of goods and services, and the economy can produce using its entire resources. The LRAS curve is also called potential output, because it is considered the economy's capacity.

The AD-AS model suggests that there is a short-run macroeconomic equilibrium and a long-run macroeconomic equilibrium. Short-run macroeconomic equilibrium occurs when the aggregate demand equals the short-run aggregate supply. If one of those curves were to shift due to any external factor besides the aggregate price or the GDP, the short-run macroeconomic equilibrium would form at that point.

On the other hand, long-run macroeconomic equilibrium occurs when the intersection between all three curves, AD, SRAS, and LRAS, occurs. Keep in mind that whenever there’s a shift in AD or SRAS, the economy will always tend to converge towards the long-run macroeconomic equilibrium. This means that the full-employment output is more static. The full-employment output can only change if there’s a change in LRAS.

We said that the equilibrium in the AD-AS model could change only when there’s a change in one of the three main curves. Let’s consider some of the factors that can shift these curves.

AD-AS Model: Shifts in Aggregate Demand (AD)

An event capable of shifting the aggregate demand curve is known as a demand shock. There are two main types of aggregate demand shocks, positive and negative. As Figure 2 suggests, a positive demand shock shifts the demand curve to the right, where the equilibrium occurs at a higher level of GDP, higher employment, and a higher aggregate price level.

On the other hand, a negative demand shock shifts the aggregate demand curve to the left. At the new short-run equilibrium in this case, there is a lower aggregate price level, lower employment, and a lower output level.

The main factors that cause a shift in the aggregate demand curve include:

• Consumer spending. An increase in consumer spending shifts the demand curve to the right, whereas a decrease in consumer spending shifts the demand curve to the left. Any factor that affects consumer spending can also influence and shift the AD curve. For instance, if the interest rate were to rise unexpectedly, it would cause consumer spending to decrease as they would want to save more rather than spend. This would shift the aggregate demand curve to the left.

• Investment spending. Whenever there is an increase in investment spending in the economy, the AD curve will shift to the right. On the other hand, a decrease in investment spending would cause the AD curve to shift to the left. Any factor that influences investment spending can influence the AD curve. For example, if there are negative expectations about future investment returns, it will cause the investment spending to fall; hence, the AD curve shifts to the left.

• Government spending. An increase in government spending causes the AD curve to shift to the right, whereas a decrease in government spending causes the AD curve to shift to the left. Again, any factor that affects government spending will also impact the AD curve. If the U.S government goes to war, the AD will shift to the right, and prices will rise in the economy.

• Net exports. Net exports also shift the aggregate demand curve. An increase in net exports will cause the AD curve to move to the right and vice versa.

AD-AS Model: Shifts in Short-Run Aggregate Supply (AS)

A factor or event that causes a shift in the short-run aggregate supply is a supply shock. Supply shocks can be positive or negative. A positive supply shock causes the short-run supply curve to shift to the right, which results in higher output, higher employment, and lower prices. On the other hand, a negative supply shock causes the short-run supply curve to move to the left, which results in lower production, lower employment, and higher prices.

Figure 3 shows the effect of a negative supply shock. As a result of this supply shock, the GDP drops, and the aggregate price level increases. An important thing to note here is that whenever you have a negative supply shock, which comes with a fall in output and price increase, the economy is in stagflation.

Many factors cause a supply shock. Main types of supply shocks include:

• Commodity prices. Whenever there is an increase in commodity prices, the SRAS curve will shift to the left. This is because commodities are often inputs to the production process. If commodity prices rise, then production costs are higher. On the other hand, whenever the prices of commodities decrease, production is cheaper and the SRAS shift to the right.

• Nominal wages. Nominal wages are also capable of influencing, or shifting, the SRAS curve. Whenever there is an increase in nominal wages, the SRAS shifts to the left. This is because labor is another input in the production process.

• Productivity. Productivity is also capable of influencing the SRAS curve. A fall in productivity means each worker can produce fewer units, so there is less production overall; hence, the SRAS shifts to the left. An increase in productivity means that the total level of output produced by a firm increases, which on an aggregate level, causes the SRAS to shift to the right.

Relationship between Inflationary Gaps in the AD-AS model

An inflationary gap is something that can be modeled using the AD-AS model. It occurs when there is a shift in the short-run equilibrium that involves more output and higher prices. The output gap is the difference between the new higher actual output and the potential output, which is defined by the LRAS.

Figure 4 shows one example of an inflationary gap and AD-AS model. Assume that the economy is initially in Equilibrium E₁, where Real GDP is Y₁ and the aggregate price level in the economy is P₁. As a result of a positive demand shock, the model results in a new equilibrium at E₂. Now there are higher prices, a higher level of output, and an inflationary gap.

Figure 4 illustrated an inflationary gap in which aggregate demand shifted right. Another possibility is that the SRAS curve shifts right. In both cases, aggregate output increases, and there is an inflationary gap.

Alternatively, if aggregate demand shifts left, or SRAS shifts left, then the new actual output is lower than the potential, or long-run output. The output gap is now negative. In this case, the difference between Y₁ and Y₂ is called a recessionary gap.

Monetary Policy in the AD-AS Model

Monetary policy is carried out by the Federal Reserve, which can raise or lower interest rates. Monetary policy plays an important role in the AD-AS model. Monetary policy has a huge impact on the number of loanable funds available and the interest rate in the economy, which in turn affect several components of the aggregate demand (AD) curve.

When there is expansionary monetary policy, meaning interest rates are lowered, the aggregate demand shifts to the right, and when there is a contractionary monetary policy, meaning interest rates are raised, the AD curve shifts to the left.

Let’s consider the case when there is an expansionary monetary policy.

Figure 5 shows the scenario that happens in the event of an expansionary policy by the FED.

Expansionary monetary policy comes in the form of lowering interest rates, which spurs consumer spending and investment spending to increase in an economy. This shifts the AD curve to the right. The equilibrium shifts from E1 to E2. The new equilibrium results in higher prices and a higher level of GDP. This is a short-run effect.

What happens next? As prices increase, people will demand higher wages to match the aggregate price increase in the economy. Higher wages will cause the SRAS to shift to the left, and there will be a new equilibrium at E3. At this point, the equilibrium occurs at the full employment level of output but at a higher aggregate price level.

AD-AS Model Example

A good example of the AD-AS model is the increase in oil prices experienced by economies around the world starting in April of 2022. The increase in oil prices makes companies' production more expensive, which causes the short-run aggregate supply to shift to the left. This results in higher prices and a lower level of output. This causes a recession as the total output in the economy falls. This type of recession is known as stagflation, and it is one of the hardest ones to address.