AS/ AD Model

2.  Mere aggregation of the microeconomic model.
 Useful for evaluating factors and conditions which
affect the level of Real Gross Domestic Product
(GDP adjusted for inflation) and the level of
inflation.

3.  AD curve has traditional negative slope.
 AD is the total demand (total spending) for a
country’s goods and services at a given price level
in a given time period.
AD = C + I + G + ( X – M)

4.  The AD curve shows the relationship between the
average price level and real output.
Price level
0
p
y
Real GDP/National Income/
National output/Real output
AD

5.  Consumption (C) :
Total spending by consumers on domestic goods and
services.
For example durable goods such as cars, mobile
phones,(long period) and non durable goods such as
rice, newspaper, toilet paper. (short period)

6. What causes changes in consumption:
 Changes in income
 Changes in interest rates
 Changes in wealth
 Changes in expectations and consumer confidence

7. Investment (I):
 Represents addition of capital stock (factories,
machines, computers) to the economy.
 Represents investments carried out by firms, for
example: replacement investment and induced
investment

8. What causes changes in investment?
 Interest rates
 Changes in the level of national income
 Technological changes
 Expectations and business confidence
For example, the diagram for investment shows:

9.  Government spending:
Government spending represents the variety of goods
and services spent on health, education, transport, law
and order, social security, housing and defence.

10. What causes changes to government spending?
 Commitment to financial support to industry
 Spending to correct market failure
 New education or health policy – new schools or
hospitals

11. Net Export: (X-M)
X = export:
Export are domestic goods and services bought by
foreigners.
M = import:
 Imports are goods and services bought from
foreign producers.
 Imports is also an outflow of import
expenditure.
 When export revenue exceeds import expenditure, this
is positive. Increase AD.
 When import expenditure exceeds export revenue, this
is negative. Reduce AD.

12. When price in the economy falls from p to p1,
C+I+G+(X-M) increases from Y to Y1.
AD = C+I+G+(X-M)
P
0
P
P1
Y Y1 Real output

13. Changes in AD:
 Changes in price causes a movement along the AD
curve, from one level of real output to another
 Changes in the components of AD will cause a shift in
the demand curve.

15.  A change in AD is caused by a change in an
influence on AD other than a change in price level;
 An increase in AD is a rise in planned spending
and is represented by a shift to the right of the AD
curve;
 A decrease in AD is shown by a shift to the left of
the AD curve

16. ◦ An increase in government spending, which may
occur in a deliberate attempt to increase AD;
◦ An increase in consumption arising from an increase in
wealth, an increase in the money supply, a cut in
taxation, a rise in population, increased optimism (‘feel-
good factor’) etc.

17. ◦ An increase in investment due to change in
technology, a rise in expectation, a fall in the rate of
interest;
◦ An increase in export because of a rise in quality, a fall
in the country’s exchange rate, a rise in income abroad.

18. I
7%
4%
0
I1 I2 Investment
Interest rate
The relationship between investment and interest rate shows when interest rate
Decreases, there is no incentive to save, and lead to increase in borrowing, which
increases investment from I1 to I2. Increase in interest rate will have the opposite
Effect.

19. What causes changes in net export?
 Export:
If foreign income rises, this leads to more imported
goods and services being consumed.
 Import:
When national income grows, this leads to an increase
in consumption. As more goods and services are being
consumed, some of these will be imported goods.

20. Government policies affecting AD:
 Fiscal policy – taxes
 Expansionary fiscal policy
 Monetary policy – interest rates

21.  Aggregate supply is the total quantity of goods
and services firms are willing and able to sell at a
given price level in a given period of time.
The Short Run Aggregate Supply (SRAS) Curve

22.  The Short Run Aggregate Supply (SRAS) curve is
drawn on the assumption that the prices of all
factors of production are fixed;
 The curve slopes up from left to right, this is
because higher output is likely to raise the cost
per unit produced and therefore to supply more,
firms have to charge a higher price;

23.  A rise in the price level is likely to encourage firms
to raise output in the short run;
 Influences other than a change in the price level
cause firms to change how much they wish to
supply the different values of the price level and
shift the SRAS.

24. ◦A change in weather condition
◦A change in raw material costs
◦A change in wage rates
◦A change in corporation tax

25. The Long Run Aggregate Supply (LRAS)
Curve
 In the long run, wage rates and the prices of
other inputs can change.
There are two main views on the shape of LRAS
Curve.

26.  The idea of the long run AS curve is that in the
long run, the real productive capacity of an
economy does not vary (i.e., is perfectly inelastic)
with respect to changes of the price level, a
nominal quantity, but it may vary with changes of
real phenomena, i.e., real matters such as
resource availability, productivity, and
technological changes.
 The long run changes of these real phenomena
may be depicted in the short-run analysis as shifts
or drifts of LRAS to the right with on-going growth,
or as leftward shifts consequent upon supply-
shocks that may have lasting adverse effects on
the economy's output capacity.

27. The long run AS curve
AS
Real output
Price
AD
SRAS
e

28.  When nominal wages are flexible, as usually
assumed in the long run, the AS curve is
perfectly vertical.
 Another reason is that the total amount of
goods that the economy produces when all
factors are efficiently used at their normal
rate of utilization does not vary with the price
level. In the long run, price does not affect the
AS, rather AS depends in the availability of
the factors of production.

29. The New Classical view is that the LRAS curve is
vertical.
 Reason: The classical view believes that if there
is unemployment, wages will fall to restore full
employment, therefore in the long run the
economy will operate at full employment hence
the vertical supply curve.

30.  The Keynesian view is that the shape of the long
run aggregate supply (LRAS) curve can be
perfectly elastic at low levels of economic activity,
less elastic at higher levels and perfectly inelastic
when full employment is reached.

31. Reasons:
 Keynesians believe that at low output, and hence
low levels of employment, the LRAS curve will be
horizontal due to considerable spare capacity in
the economy and output can be increased without
raising cost per unit produced;

32.  Keynesians also believe that as pressure begins
to be placed on capacity and shortages in skilled
labour occur, unit costs begin to rise and the
LRAS curve slopes upwards;
 Once the full employment level is reached, it is not
possible to raise output and the LRAS curve
becomes vertical.

33. Note: The New Classical economists and the
Keynesian economists both agree that, if full
employment is reached, the LRAS curve will be
vertical.
 A change in LRAS is a change in the production
potential of the economy;
 An increase in the LRAS is shown by a shift to the
right of the LRAS and a decrease by a shift to the
left;

34. The quantity of factors of production increases due
to
1. an increase in investment,
2. discovery of new materials,
3. an increase in the size of the labour force;
The quality of factors of production increases due
to:
1 improvement in education and training,
2. technological progress, this will raise productivity
(output per worker hour).

35.  Macroeconomic equilibrium occurs where
Aggregate Demand meets Aggregate Supply.
 Only at the combination of GDP and price level
given by the intersection the AD and AS curves
are spending behavior (demand) and
production (supply) activity consistent.
 A shift in either the AD or the AS curve leads to
changes in the equilibrium values of the price
level and real GDP.

36. AD
AS
Y0
P0
Real output
Price
e

37.  If the price level deviates from this equilibrium (P0),
pressures on business and consumers will move the
economy back toward point e.
 Two conditions should be satisfied to attain
macroeconomic equilibrium: (1) at the prevailing price
level, desired expenditure must be equal to national
output. The idea is agents are willing to buy all that is
produced. The AD curve is constructed in such a way
that this condition holds everywhere on it. (2) at the
prevailing price level, firms must wish to produce the
prevailing level of national output, no more and no less.
This is introduced by the consideration of AS.

38.  Although the economy is self-correcting in the long-run,
this process can take up to a decade or more.
 Particularly, if output is below potential output, the
economy can suffer an extended period of depressed
aggregate output an high unemployment during this
period of self-correction.
 John Maynard Keynes: “In the long run we are all dead.”
He recommended that governments not wait for the
economy to correct itself, but use fiscal policy to get the
economy back to potential output more quickly.

39.  This is the rationale for active stabilization policy,
which is the use of government policy to reduce the
severity of recessions and control excessively strong
expansions.
 However, the ability to improve the economy’s
performance is not always guaranteed; it depends on the
kinds of shocks the economy faces.

40.  This is the rationale for active stabilization policy,
which is the use of government policy to reduce the
severity of recessions and control excessively strong
expansions.
 However, the ability to improve the economy’s
performance is not always guaranteed; it depends on the
kinds of shocks the economy faces.

41.  If policy makers react quickly to a negative demand shock,
they can use monetary or fiscal policy to shift the aggregate
demand curve back to the right.
 If it was possible to anticipate shifts of the AD curve and
counteract them, it could short-circuit the whole process of
going through a period of low aggregate output and falling
prices.
 This is desirable because:
1. The temporary fall in aggregate output is associated with high
unemployment.
2. Price stability is regarded as a desirable goal (avoiding deflation-
a fall in the aggregate price level.

42.  However, some policy measures to increase aggregate
demand may have long-term costs in terms of lower long-
run growth.
 It also could be that the policy-makers are not perfectly
informed, and the effects of their policies are not perfectly
predictable. This could cause the attempts to create more
stability to end up creating more instability.
 Despite this, many economists believe in the use of
macroeconomic policy to offset major negative shocks to
the AD curve.

43.  The effect of a negative supply shock is to lower
aggregate output but increase to a higher aggregate price
level.
 Two bad things happen simultaneously: a fall in
aggregate output leads to a rise in unemployment, and a
rise in the aggregate price level decreases the purchasing
power of incomes.
 In contrast to the case of a demand shock, there are no
easy remedies for a supply shock. This means that there
are no government policies that can easily counteract the
changes in production costs that shift the SRAS curve.

44.  Using monetary or fiscal policy to shift the AD curve would
do one of two things:
a) A policy to increase AD to limit the rise in unemployment
would reduce the decline in output but cause even more
inflation.
b) A policy to decrease AD, it curbs inflation but causes a
further rise in unemployment.
 This is then a trade-off with no right answer; it requires
facing harder choices than usual.
 In the end, economic policy eventually chooses to
stabilize prices at the cost of higher unemployment.

45. THANK YOU..
