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Understanding the AS/AD Model: Analyzing Equilibrium, Gaps, and Economic Changes

The AS/AD model is a fundamental tool in AP Macroeconomics that illustrates the economy's equilibrium output (GDP) and price level. It identifies full employment equilibrium at the intersection of AD, SRAS, and LRAS. This model highlights recessionary and inflationary gaps based on output deviations from full employment levels. Changes in aggregate demand (AD) and aggregate supply (SRAS) due to factors like consumption, investment, government spending, and input prices directly affect GDP and price levels. Understanding these dynamics is crucial for analyzing economic fluctuations.

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Understanding the AS/AD Model: Analyzing Equilibrium, Gaps, and Economic Changes

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  1. AP Macroeconomics The AS/AD Model

  2. The AS/AD Model • The equilibrium of AS & AD determines current output (GDPR) and the price level (PL) • If equilibrium of AS & AD is ON LRAS: • Unemployment is 3-4% • Output is where it “should” be • Also at a point ON the PPC

  3. Full Employment • Full Employment equilibrium exists where AD intersects SRAS & LRAS at the same point. LRAS SRAS PL P AD YF GDPR

  4. Recessionary Gap • A recessionary gap exists when equilibrium occurs below full employment output. SRAS LRAS PL P AD Y YF GDPR

  5. Inflationary Gap • An inflationary gap exists when equilibrium occurs beyond full employment output. LRAS SRAS PL P AD YF Y GDPR

  6. Changes (Δ)in AD • Δ Consumption (C) • C↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ • C↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ • Δ Gross Private Investment (IG) • IG↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ • IG↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓

  7. Changes (Δ)in AD (cont) • Δ Government Spending (G) • G↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ • G↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ • Δ Net Exports (XN) • XN↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ • XN↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓

  8. Increase in AD SRAS LRAS PL  P1  P AD1 AD  Y YF GDPR C↑, IG↑, G↑ and/or XN↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑

  9. Decrease in AD LRAS PL SRAS  P  P1 AD AD1  YF Y GDPR C↓, IG↓, G↓ and/or XN↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓

  10. Changes (Δ)in SRAS • Δ Input Prices • Input Prices↓ .: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ • Input Prices↑ .: SRAS  .: GDPR↓ & PL ↑ .: u%↑ & π%↑ • Δ Productivity • Productivity↑ .: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ • Productivity↓ .: SRAS  .: GDPR↓ & PL ↑ .: u%↑ & π%↑

  11. Changes (Δ)in SRAS (cont) • Δ Legal-Institutional Environment • Deregulation .: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ • Regulation .: SRAS  .: GDPR↓ & PL ↑ .: u%↑ & π%↑

  12. Increase in SRAS SRAS LRAS PL SRAS1  P  P1 AD  Y YF GDPR Input Prices↓, Productivity↑, and/or Deregulation .: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓

  13. Decrease in SRAS SRAS1 LRAS PL SRAS  P1  P AD  Y1 YF GDPR Input Prices↑, Productivity↓, and/or Regulation/Business Taxes ↑ .: SRAS  .: GDPR↓ & PL↑ .: u%↑ & π%↑

  14. AS / AD Summary • ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD • AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ • AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ • Δ Input Prices, Δ Productivity, and/or Δ Regulation = Δ SRAS • SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ • SRAS  .: GDPR↓ & PL ↑ .: u%↑ & π%↑

  15. Increase in G with an increase in Taxes increases AD. (Multiplier) • The AS/AD Model is the most important graph in AP Macroeconomics. • KNOW IT!!!

  16. Assume the US economy is in a state of full employment. • Draw a correctly labeled AS/AD graph showing representing that fact. • Now suppose that private investment decreases. Show the effect of that decrease on your AS/AD graph. • Explain the impact of the decrease in private investment.

  17. Long-Run Aggregate Supply (LRAS) • scenario to illustrate the point that we will always (hopefully) come back to LRAS and why/how LRAS is independent of price level • To produce more than full employment output overtime is necessary. • Input costs (labor) will go up • When input costs are free to change, the high demand for them will start to raise input costs and lead to cost push inflation

  18. Long-Run Aggregate Supply (LRAS) • As input prices increase firms profits will fall until rise in input prices match the change in output prices. • Firm profits return to original levels and firms will be motivated to produce at FE output level

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