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The AD/AS Model

Remember the goals for a macro-economy:

• Growth in production of real goods.
• Stable price levels and stable money.
• Full employment of resources, particularly labour
• Cyclical stability – avoid recessions.

One concern of macroeconomic models and theories focuses on the decisions and dynamics that result in producing real GDP. These models and theories are primarily interested in:

• Whether an economy that is in recession will recover on its own?
• What happens if the decentralized production plans of all firms and workers adds up to more (or less) than the economy is capable of producing?
• How will inflation/deflation affect the decisions of households and firms about how much to consume or produce?
• Whether the government should balance its budget (have taxes = govt spending), Or should it run a deficit?
• Whether government is needed to stabilize the economy and achieve full employment?

A Word About Models in Macro

Contrary to the suspicions of some students, economists do not use graphs and models simply to torture students in principles classes. (that may simply be a side-effect depending on your comfort level with maths).  Instead, models are a critical tool for economists to use when formulating a theory.  The essence of any theory is really a story of “how things relate or work”.  A theory can be expressed or defined in several ways.  It can simply be a verbal story or it can be a set of data.  Both are valid ways to express a theory.  A “model” is really the same as a theory but with a little more formality to it.  A model is a simplification of reality. It doesn’t include everything.  Instead it tries to include and describe the relationships between the most important factors. Economists have found mathematics extremely useful (and at times distracting) when creating models of the economy.  The benefit of using mathematics to describe our models and relationships is because mathematics forces us to both define terms and enforce logic on our arguments.

In higher economics (intermediate, graduate, and research levels) economists typically use algebra, calculus, and topology to define their models.  Don’t worry, we will only use the most elementary algebra in this course (equations like:  C+I+G+(X-M) = Q).  Instead of the more formal systems of equations and calculus, we’ll use a set of simple graphs.  In fact, we’ll use fewer graphic models than you learned in microeconomics.

The one model we will use is the AD- AS model.  In plain language it’s called the Aggregate Demand-Aggregate Supply model.  We will use this model for two reasons.  First, it’s a very handy, simple way to say a lot.  In one simple x-y coordinate graph with 3 curves on it, we can illustrate a variety of different conditions of an economy.  As we trace the movement of an economy in the graph (each point represents unique conditions in the economy) we can evaluate whether we making progress towards all four of our major macro economic goals. The model also allows us to conveniently contrast the dynamics that the two major theories, Classical and Keynesian, suggest will occur.

One major limitation of the AD-AS model is an exclusive focus on the “real sector”.  The real sector is the world of households, firms, government and trade with the ROW.  It deals with the production of real goods and services (GDP) from real resources (labor, natural resources, capital assets). The model doesn’t directly address the financial sector and the creation of money. For now, this is adequate for our purposes. Later, we’ll expand our analysis to include the workings of the financial sector.

The Aggregate Demand and Aggregate Supply Model (AD-AS)

Despite its apparent similarity (in name) to the Supply & Demand models of micro, the Aggregate Demand-Aggregate Supply Model is very different. In this model, called the AD-AS model, we have two different curves relating how everybody together in the economy (the aggregate) will react in different conditions. The conditions are defined as a combination of the Price Level and the level of Real Output (measured as Real GDP).

The Price Level represents a way of measuring whether prices of most goods are moving up or moving down. This is significantly different from Micro S&D models. In Micro S&D models, the “price” variable represents the real price of acquiring a particular item – it’s a way of measuring what you have to give up (opportunity cost) in order to buy something. In the AD-AS model, the vertical axis represents Price Level. Price Level illustrates questions of inflation or deflation and the amounts of money needed to buy goods. Since Price Level is  an “average price of everything”, it isn’t so important whether we are at a high Price Level or at a low Price Level. A higher price level just means the numbers on all prices are higher. But since your wages are the price of your labour, that means your income is also in larger amounts.

What’s most important about Price Level in the AD-AS model is whether & how the Price Level changes. It’s less important whether the Price Level is high or it’s low. It’s much more important to know whether the Price Level is going up or going down or staying the same.

To better understand these AD-AS Graphs, think of the vertical axis (the Price Level) as being an index of inflation such as the CPI index. The horizontal axis is quantities of real, physical goods that can be consumed and used. This Real Output (Real GDP ), represents how many “goods” or services we (all together) are producing for all of us to consume. This model doesn’t have anyway of distinguishing questions of distribution or even of types of goods. Everything we produce is lumped together on a single linear axis running from zero (we didn’t produce anything at all) to a very large and increasing number (we produced a lot of stuff). Needles to say, more stuff is better. So being to the right on the Real GDP scale is a good thing.

AD-AS: Explanation & Example

It helps me to think of the AD-AS model as describing probable reactions of buyers and sellers of final goods (GDP). In other words, I assume we’re starting from some equilibrium – the economy is starting from the intersection of the AD and SRAS curves. In other words, we are at some particular Price Level and we are producing some particular amount of Real Output (Real GDP). So far, all we have is point on our graph.

The AD curve represents how buyers will react if there’s an increase in the Price Level. Remember the Price Level represents an average price of ALL goods & resources – so an increase in Price Level is what we call inflation. The price of everything is going up – some goods faster than others, but most are going up. The AD curve’s downward slope means that if Price Level rises, then we (all of us in total) will be willing to buy less stuff and fewer goods. Why? We’ll explore why in-depth in a later chapter, but for now it’s enough to realize that when all prices are going up, most people will keep buying what they’ve been buying because their incomes will also be going up. Wages are a price, so when all prices go up, your wage income goes up as well as the price of what you buy. The catch is that this isn’t true for all buyers. Some people have fixed incomes (they don’t sell their labor). Some people are spending their savings. For these people, higher prices means their fixed income/savings buys less goods. So, in aggregate, the total amount of goods bought when the Price Level rises is less. In other words, Real GDP and Price Level are inversely related.

The AS curve represents how sellers will react if there’s an increase in the Price Level. In the longer run, higher prices for everything shouldn’t affect how much sellers are willing to produce and sell. After all, if the price of what they are selling may go up, but so will the prices of the inputs and resources. Sellers only want to produce and sell more (higher Real GDP) if the profitability improves. Profitability is the difference between costs and sales revenue. If sales price is going up AND input prices (costs) are also going up, then profitability isn’t improved and there’s no reason to produce more output or to expand production.

The problem for firms is in recognising what’s going on when inflation is occurring. In most cases, when the price of what they’re selling goes up, most firms and sellers don’t realise that it may only be due to inflation. When you’re the seller, it’s easy to see that your selling price is rising – it’s harder to realise that you’re not unique. After all, a seller of clothing might easily recognise when they can raise the price of blue jeans. But they aren’t likely to know that at that same time the cost of labor at the blue jean factory, the price of cotton in the field, and the price of transport are all increasing the same amount. They aren’t likely to realise that the next pair of jeans they buy from the manufacturer to replace the ones they just sold will be at higher prices. Suppose all prices are rising. In the short-term, until they find out otherwise, firms and producers think profitability has improved with a higher sales price and the older costs. So, they initially react by being willing to produce more when the Price Level rises. Eventually they figure it out and correct it, but the AS curve accurately plots the short-term reaction. For this reason, I prefer to call the AS curve the SRAS curve, for Short-Run Aggregate Supply curve.

In AD-AS analysis, there is a third “curve”, often called the Long-Run Aggregate Supply (LRAS). Actually it’s more of vertical line at whatever level of real GDP represents the economy’s capacity to produce. In other words, if the economy is actually performing at its maximum and using all its available input resources, then in PPC model terms, it’s on the PPC curve. In AD-AS terms, the economy is on the LRAS. If the economy is producing a real GDP that’s to the left of LRAS (less than capacity), then it indicates that some unemployment exists and we are capable of producing more goods, but we aren’t using all our resources. If the economy is to the right of LRAS, it means that we are trying to produce goods at an unsustainable rate — we’re actually producing beyond our capacity. Of course producing beyond-capacity is only possible in the very short-run. It’s kind of like studying all night for an exam. You are producing “hours studied” at a rate that is possible for one night, but isn’t sustainable for the entire semester. Likewise, any economy that finds itself producing real GDP to the right of LRAS (real GDP > full employment) can’t do it for very long. Eventually it has to return to LRAS or less.

It is also useful to realize that LRAS represents the level of output or real GDP the economy is capable of producing when it has full employment. But, we need to also remember from our unit on unemployment that “full employment” does NOT mean a the unemployment rate = 0%. At “full employment” there will still be frictional unemployment. For this reason, some economists refer to the level of real GDP represented by LRAS as “Natural Employment Output”. Other economists prefer the term “potential output” as representing LRAS. Personally, I call it “full employment real GDP”.

AD-AS Gaps: Expansionary (inflationary) and Contractionary (recessionary)

If all three curves, AD, SRAS, and LRAS, all intersect at the same point we have equilibrium. Everything’s fine. We have achieved our macro economic goals of full employment and stable prices. If the capacity of the economy keeps expanding, then LRAS will start moving slowly to the right. We get more resources, so we have more capacity, so LRAS moves to the right.

If the other two curves also shift at the same time we might also achieve our goal of growth and stability. But what if LRAS moves and AD and SRAS don’t shift? That’s the key question behind AD-AS analysis.

If AD & SRAS intersect to the left of LRAS, we are at an equilibrium, but unemployment exists. We are in what is called a recessionary or contractionary gap.

If AD & SRAS intersect to the right of LRAS we are temporarily at an unsustainable equilibrium. We’re trying to produce and sell more goods than we are capable of producing long-run, given the current prices. Prices must rise. The SRAS and AD will shift until they both intersect at the LRAS again, only it will be at higher prices. We have an inflationary or expansionary gap.

THE AD-AS Question: Will markets self-correct?

Now we get to the most important question in the macro-economics of the real sector. Do markets self-correct? Will an economy in an inflationary gap (expansionary gap),self-correct and return to equilibrium (LRAS) without inflation? Will an economy in a recessionary gap (contractionary gap) self-correct and return to full-employment (LRAS)? In other words, will a market system be self-correcting and always achieve our macro-economic goals? Or, is government intervention necessary to achieve stability and full-employment?

As mentioned earlier, there are two major views or theories that attempt to answer these questions. The two theories, Classical and Keynesian, have very different conclusions with regard to the desirability of government involvement in the economy. To understand the essence of these two theories, and why they reach the conclusions they reach, it is useful to look at the two “gap situations”, a recessionary gap and an inflationary gap. (they are also called contractionary and expansionary gaps). Each of the two major theories offers a different view on how decisions are made in the economy and how an economy will react when it is in one of these gaps. We will look at the Classical theory in another section of the site.