How the AD/AS model incorporates growth, unemployment, and...

How the AD/AS model incorporates growth, unemployment, and inflation

Posted 2023-03-31 19:57:02

Key points

The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.
We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram.
Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP.
The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram.
Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

The AD/AS model allows economists to analyze multiple economic factors.

Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts including the three macroeconomic goals of growth, low inflation, and low unemployment; the elements of aggregate demand; aggregate supply; and a wide array of economic events and policy decisions.

The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing these factors together in one diagram. In addition, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach—focusing on aggregate demand and the short run—while also including the Say’s law approach—focusing on aggregate supply and the long run.

Growth and recession in the AD/AS model

We can examine both long-term and short-term changes in gross domestic product, or GDP, using the AD/AS model. In an AD/AS diagram, long-run economic growth due to productivity increases over time is represented by a gradual rightward shift of aggregate supply. The vertical line representing potential GDP—the full-employment level of gross domestic product—gradually shifts to the right over time as well. You can see this effect in AD/AS diagram A below, which shows a pattern of economic growth over three years.

However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in an AD/AS diagram.

In the short run, GDP, falls and rises in every economy as the economy dips into recession or expands out of recession. When an AD/AS diagram shows an equilibrium level of real GDP substantially below potential GDP—as is shown in the diagram below at equilibrium point start text, E, 0, end text—it indicates a recession. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP—as it is at equilibrium point start text, E, 1, end text.

Unemployment in the AD/AS diagram

We can examine two different types of unemployment using an AD/AS diagram—cyclical unemployment and the natural rate of unemployment. Cyclical unemployment bounces up and down according to the short-run movements of GDP. The long-term, baseline level of unemployment that occurs year in and year out, however, is called the natural rate of unemployment.

The natural rate of unemployment is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.

In an AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full-employment level of GDP. Take another look at the AD/AS diagram above. Relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as at the equilibrium point start text, E, 1, end text. On the other hand, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point start text, E, 0, end text.

The factors that determine the natural rate of unemployment are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP, or full-employment GDP, in a given economy.

Inflationary pressures in the AD/AS diagram

Inflation fluctuates in the short run, and higher inflation rates typically occur either during or just after economic booms. For example, the biggest spurts of inflation in the US economy during the 20th century followed the wartime booms of World War I and World War II. On the other hand, rates of inflation generally decline during recessions.

The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the aggregate supply curve. Let's look at diagram A, on the left below. In this diagram, you'll see a shift of aggregate demand to the right. The new equilibrium start text, E, 1, end text is at a higher price level than the original equilibrium start text, E, 0, end text. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.

Another source of inflationary pressures is a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor. This situation can cause the aggregate supply curve to shift back to the left. In diagram B above, the shift of the SRAS curve to the left also increases the price level from start text, P, 0, end text at the original equilibrium start text, E, 0, end text to a higher price level of start text, P, 1, end text at the new equilibrium start text, E, 1, end text. In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.

An AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years.

[So what is the answer? Why does inflation persist over time?]

Summary

The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.
We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram.
Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP.
The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram.
Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

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