7.3 Equilibrium in the AD-AS Model

The AD-AS model shows how the economy reaches equilibrium when aggregate demand meets aggregate supply. It's a key tool for understanding how changes in spending, production, and prices affect overall economic output and inflation.

This model helps explain real-world economic events like recessions and inflation. By analyzing shifts in the AD and AS curves, we can predict how things like government policies or supply shocks might impact the economy's equilibrium price level and output.

Macroeconomic Equilibrium

Concept and Graphical Representation

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• Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied in an economy
• Equilibrium is represented graphically by the intersection of the aggregate demand (AD) curve and the aggregate supply (AS) curve
• In the short run, equilibrium may occur at a point where the economy is not at full employment
  • This can happen due to sticky wages and prices that prevent the economy from adjusting quickly to changes in demand or supply
• In the long run, equilibrium tends to move towards the full employment level of output
  • As wages and prices adjust over time, the economy will gradually move towards its potential output level
• Macroeconomic equilibrium is a state where there is no tendency for change in the overall price level or real GDP, assuming no external shocks to the economy
  • At equilibrium, there is no pressure for prices or output to increase or decrease, as the quantities demanded and supplied are balanced

Short-Run and Long-Run Equilibrium

• The short-run aggregate supply (SRAS) curve is upward sloping due to sticky wages and prices
  • In the short run, firms may be unable to adjust their prices and wages quickly in response to changes in demand, leading to changes in output rather than prices
• The long-run aggregate supply (LRAS) curve is vertical at the full employment level of output
  • In the long run, wages and prices are fully flexible, and the economy will produce at its potential output level, which is determined by factors such as technology, capital stock, and labor force
• Changes in the AD or AS curves will lead to a new equilibrium price level and output, which can be found by identifying the new intersection point of the curves
  • For example, an increase in AD (rightward shift) will lead to a higher equilibrium price level and output in the short run, as firms increase production to meet the higher demand

Equilibrium in AD-AS Model

Determining Equilibrium Price Level and Output

• The equilibrium price level and output are determined by the intersection of the AD and AS curves
• The AD curve represents the total quantity of goods and services demanded at each price level
  • Factors that can shift the AD curve include changes in consumption, investment, government spending, and net exports
• The AS curve represents the total quantity of goods and services supplied at each price level
  • Factors that can shift the AS curve include changes in input prices, productivity, and the size of the labor force
• To find the equilibrium price level and output, locate the point where the AD and AS curves intersect
  • At this point, the quantity of real GDP demanded equals the quantity of real GDP supplied, and there is no tendency for prices or output to change

Effects of Changes in AD and AS

• A rightward shift in the AD curve (increasing aggregate demand) will lead to a higher equilibrium price level and a higher level of real GDP in the short run
  • This can be caused by factors such as increased consumer confidence, lower interest rates, or higher government spending
• A leftward shift in the AD curve (decreasing aggregate demand) will lead to a lower equilibrium price level and a lower level of real GDP in the short run
  • This can be caused by factors such as decreased consumer confidence, higher interest rates, or lower government spending
• A rightward shift in the SRAS curve (increasing short-run aggregate supply) will lead to a lower equilibrium price level and a higher level of real GDP
  • This can be caused by factors such as lower input prices or increased productivity
• A leftward shift in the SRAS curve (decreasing short-run aggregate supply) will lead to a higher equilibrium price level and a lower level of real GDP
  • This can be caused by factors such as higher input prices or decreased productivity
• Changes in the LRAS curve (long-run aggregate supply) will affect the full employment level of output but not the equilibrium price level in the long run
  • Factors that can shift the LRAS curve include changes in technology, capital stock, or the size of the labor force

Changes in AD and AS

Analyzing the Effects on Equilibrium

• The AD-AS model can be used to analyze the effects of various economic shocks on macroeconomic equilibrium
  • Economic shocks are unexpected events that can disrupt the economy, such as changes in government policies, natural disasters, or shifts in consumer behavior
• Changes in government spending and taxes (fiscal policy) can shift the AD curve and affect the equilibrium price level and output
  • Expansionary fiscal policy (increasing government spending or decreasing taxes) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
  • Contractionary fiscal policy (decreasing government spending or increasing taxes) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
• Changes in the money supply (monetary policy) can also shift the AD curve and affect the equilibrium price level and output
  • Expansionary monetary policy (increasing the money supply) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
  • Contractionary monetary policy (decreasing the money supply) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
• Supply shocks, such as changes in energy prices or natural disasters, can be represented by shifts in the SRAS curve and their effects on equilibrium can be analyzed using the AD-AS model
  • For example, a negative supply shock (leftward shift in SRAS) due to a natural disaster will lead to a higher equilibrium price level and lower output in the short run

Long-Run Adjustments

• In the long run, the economy will tend to move towards its full employment level of output, as prices and wages adjust to changes in demand and supply
  • The LRAS curve represents the full employment level of output, which is determined by factors such as technology, capital stock, and the size of the labor force
• Changes in the AD curve will not affect the long-run equilibrium output level, as the LRAS curve is vertical
  • In the long run, changes in AD will only affect the price level, not the level of output
• However, changes in the LRAS curve (long-run aggregate supply) will affect the full employment level of output
  • Factors that can shift the LRAS curve include changes in technology, capital stock, or the size of the labor force
  • A rightward shift in the LRAS curve (increasing long-run aggregate supply) will lead to a higher full employment level of output, while a leftward shift (decreasing long-run aggregate supply) will lead to a lower full employment level of output

AD-AS Model Applications

Fiscal and Monetary Policy

• The AD-AS model can be used to explain and predict the effects of fiscal policy on macroeconomic equilibrium
  • Expansionary fiscal policy (increasing government spending or decreasing taxes) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
    • For example, during a recession, the government may increase spending on infrastructure projects to stimulate demand and boost output
  • Contractionary fiscal policy (decreasing government spending or increasing taxes) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
    • For example, during a period of high inflation, the government may reduce spending or raise taxes to cool down the economy and reduce inflationary pressures
• The AD-AS model can also be used to analyze the effects of monetary policy on macroeconomic equilibrium
  • Expansionary monetary policy (increasing the money supply) shifts the AD curve to the right, leading to a higher equilibrium price level and output in the short run
    • For example, during a recession, the central bank may lower interest rates or engage in quantitative easing to increase the money supply and stimulate demand
  • Contractionary monetary policy (decreasing the money supply) shifts the AD curve to the left, leading to a lower equilibrium price level and output in the short run
    • For example, during a period of high inflation, the central bank may raise interest rates to reduce the money supply and cool down the economy

Real-World Economic Phenomena

• The AD-AS model can be used to understand and explain real-world economic phenomena, such as recessions, inflation, and stagflation
  • Recessions can be explained by a leftward shift in the AD curve, leading to a lower equilibrium price level and output
    • This can be caused by factors such as decreased consumer confidence, higher interest rates, or lower government spending
  • Inflation can be explained by a rightward shift in the AD curve or a leftward shift in the SRAS curve, leading to a higher equilibrium price level
    • Factors that can cause inflation include increased government spending, lower interest rates, or higher input prices
  • Stagflation, a combination of high inflation and low economic growth, can be explained by a leftward shift in the SRAS curve, leading to a higher price level and lower output
    • This can be caused by factors such as supply shocks (oil price increases) or decreased productivity
• By examining the underlying shifts in the AD and AS curves, policymakers can develop appropriate responses to economic challenges
  • For example, during a recession, policymakers may implement expansionary fiscal or monetary policies to stimulate demand and boost output
  • During a period of high inflation, policymakers may implement contractionary fiscal or monetary policies to cool down the economy and reduce inflationary pressures