What is AD-AS Model?

The AD-AS model has become one of the most powerful tools in economics. It has shaped our understanding of macroeconomics since the 1950s. The model proved especially valuable during the inflation-heavy 1970s and became the main framework to analyze economic changes.

The model achieves something remarkable. It captures our economy’s behavior through three vital curves that show the relationship between price levels and real GDP. Economic goals like full employment, price stability, and growth become clearer through this model, making it a cornerstone of modern economic analysis.

This piece explores the core parts of the AD-AS model, including aggregate demand (C + I + G + (X-M)) and aggregate supply. The model simplifies the complex systems that central banks use, which is vital to understanding macroeconomic stability and policy decisions.

Understanding the AD-AS Model Basics

The AD-AS model shows how the economy works through total demand and supply interactions. This basic framework helps us analyze how economic changes and policies affect the bigger picture.

What is aggregate demand?

Aggregate demand shows the total spending on finished goods and services in an economy at different price levels. It combines four main parts:

• Consumer spending (C): The biggest part that covers what households spend
• Investment spending (I): Money spent on capital goods and services
• Government spending (G): Public sector money used for infrastructure and services
• Net exports (X-M): The difference between what we sell abroad and buy from others

What is aggregate supply?

Aggregate supply measures how many goods and services businesses plan to make at different price levels. It comes in two forms. Short-run aggregate supply (SRAS) shows output changes with prices when costs stay stable. Long-run aggregate supply (LRAS) shows what the economy can produce when using all its resources well.

How do they work together?

The way aggregate demand and supply interact sets the price level and real GDP in an economy. Businesses make more products along the aggregate supply curve when aggregate demand goes up. This balance between spending and production ends up shaping economic growth and stability.

The model explains economic changes through these interactions really well. The economy moves to a new balance point when demand or supply changes, and this affects both prices and output levels.

Key Components of the AD-AS Graph

The AD-AS graph’s visual elements help us understand complex economic relationships. The graph uses two main axes that represent vital economic measurements.

The vertical axis: Price level

The vertical axis shows the price level – the average of current prices for all goods and services in the economy. This measurement is different from individual product prices you see in microeconomic graphs. Broad indicators like the Consumer Price Index or GDP deflator track these overall price movements.

Money’s purchasing power depends on the price level. When prices go up, each currency unit buys less. This makes the vertical axis vital to analyze inflation and deflation in the economy.

The horizontal axis: Real GDP

Real GDP appears on the horizontal axis. It measures the total value of final goods and services produced in an economy after adjusting for inflation. This axis shows both the economy’s output and national income levels.

Real GDP relates to employment levels too. Higher Real GDP usually means more jobs are available. This makes the horizontal measurement valuable for policymakers who monitor economic health.

These two axes work together to create a useful analytical tool. Any point on the graph gives us the Nominal GDP when we multiply the price level by Real GDP. Economists and policymakers use this to track real economic growth and price changes at the same time.

How Changes Affect the AD-AS Model

Economic conditions constantly shape the AD-AS model. These changes create natural movements that affect both price levels and output.

Shifts in aggregate demand

Changes in consumption, investment, government spending, or net exports cause demand shocks. The AD curve moves to the right when demand increases. This movement pushes both price levels and real GDP higher. Lower interest rates, increased consumer confidence, or higher government spending can trigger this positive demand shock.

Negative demand shocks make the AD curve move left. This results in lower price levels and decreased real GDP. Reduced consumer confidence, higher interest rates, or decreased government spending often cause these shifts.

Shifts in aggregate supply

Supply shocks change the economy’s production capacity and costs. The SRAS curve moves right during a positive supply shock and left during a negative one. Several factors influence these movements. The main drivers include:

• Resource prices (labor, raw materials)
• Technological advancements
• Government policies (taxes, regulations)
• External economic events

Finding the equilibrium point

The equilibrium price level and real GDP emerge where aggregate demand and supply curves meet. Short-run equilibrium happens where AD meets SRAS. Long-run equilibrium needs to line up with potential GDP.

A recessionary gap forms when the equilibrium point drops below potential GDP. An inflationary gap appears when equilibrium exceeds potential GDP. Policymakers use their understanding of these gaps to spot economic imbalances and take corrective action.

Real-World Examples of AD-AS Model

Real-life economic events show how the AD-AS model explains major economic changes. Historical cases help us analyze complex economic situations better.

The 2008 financial crisis

The 2008 financial crisis shows the AD-AS model at work. The U.S. economy faced a negative supply shock because oil and commodity prices went up. The housing market collapse then caused a major drop in total demand.

This crisis hit hard. The U.S. gross domestic product dropped 4.3% from its peak, making it the worst recession since World War II. Unemployment more than doubled from 5% to 10%. The Federal Reserve took bold steps and cut the federal funds rate from 4.5% to almost zero by late 2008.

COVID-19 economic impact

The COVID-19 pandemic created an unusual economic situation that clearly shows the AD-AS model’s usefulness. The economy took hits from both demand and supply sides throughout 2020. GDP fell 6.6% in the first quarter because of reduced demand.

Things got worse in the second quarter when GDP crashed by 34.3% annually. Supply disruptions caused two-thirds of this drop, while decreased demand led to one-third. The pandemic’s effects showed up in several ways:

• Closed businesses limited supply
• Stay-at-home orders pushed unemployment from 3.5% to 14.7%
• Essential goods became more expensive
• People spent less as they lost income

The government stepped in with stimulus checks and better unemployment benefits to boost total demand and steady the economy. These real-life examples show how the AD-AS model helps us understand complex economic changes.

Conclusion

The AD-AS model serves as a key framework that helps us understand complex economic dynamics through simple visual representation. At first glance it might seem complicated, but this model breaks down nationwide economic activity into two simple parts – total demand and supply.

Recent events like the 2008 financial crisis and COVID-19 pandemic show how useful this model is in real life. These examples demonstrate the impact of external shocks on both the demand and supply sides of the economy. Such shocks lead to major changes in GDP and price levels.

Students, economists, and policymakers find the AD-AS model helpful because it knows how to explain economic fluctuations clearly. This model helps them learn about how different factors influence price levels and national output instead of getting lost in economic complexity. They can predict economic outcomes and evaluate policy effectiveness better by understanding these relationships.

This model remains fundamentally important for economic analysis. The AD-AS framework continues to give valuable insights about maintaining economic stability and growth as economies face new challenges.