Aggregate Demand-Aggregate Supply
The AD-AS model has become the standard textbook model for explaining the macroeconomy. This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels. The downward slope is the result of two effects: the Pigou or real balance effect, which states that as real price fall real wealth increases, so consumers demand more goods, and the Keynes or interest rate effect, which states that as prices fall the demand for money declines causing interest rates to decline and borrowing for investment and consumption to increase. In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential output, which corresponds with full-employment. Since the economy cannot produce beyond more than potential output, any AD expansion will lead to higher price levels instead of higher output.
The AD-AS diagram can model a variety of macroeconomic phenomena including inflation. When demand for goods exceeds supply there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels. The AS-AD diagram is also widely used as pedagogical tool to model the effects of various macroeconomic policies.
Famous quotes containing the words supply and/or aggregate:
“There never has been a time in our history when work was so abundant or when wages were as high, whether measured by the currency in which they are paid or by their power to supply the necessaries and comforts of life.”
—Benjamin Harrison (18331901)
“a fortress against ideas and against the
Shuddering insidious shock of the theory-vendors
The little sardine men crammed in a monster toy
Who tilt their aggregate beast against our crumbling Troy.”
—Louis MacNeice (19071963)