Macroeconomic Policy - Macroeconomic Models - Aggregate Demand-Aggregate Supply

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.

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