Ch8. The AD-AS Model and Business Cycles — Reading the Economy Through Aggregate Demand and Supply

What Is the AD-AS Model?

The AD-AS model represents the aggregate demand and supply of an entire national economy in a single graph. It is the central tool of macroeconomic analysis.

AD (Aggregate Demand): The total quantity of goods and services all economic actors wish to purchase at a given price level
AS (Aggregate Supply): The total quantity of goods and services firms are willing to produce at a given price level

This model is used to analyze recessions, inflation, supply shocks, and policy effects.

The Aggregate Demand (AD) Curve

Why the AD Curve Slopes Downward

As the price level rises, real GDP (aggregate quantity demanded) falls. Three mechanisms:

1. Wealth Effect Price level rises → real value of financial assets falls → consumption falls

2. Interest Rate Effect Price level rises → money demand increases → interest rates rise → investment falls

3. Exchange Rate Effect Price level rises → domestic goods become relatively more expensive → exports fall, imports rise

Factors That Shift the AD Curve

AD shifts right (increases):

Consumption increases (higher household income, stronger consumer confidence)
Investment increases (business optimism, lower interest rates)
Government spending increases (fiscal expansion)
Net exports increase (stronger foreign demand, weaker domestic currency)

AD shifts left (decreases):

The reverse of all the above

The Aggregate Supply (AS) Curve

The AS curve requires a distinction between short run and long run.

Short-Run Aggregate Supply (SRAS)

In the short run, wages and prices are sticky. When prices rise, firms’ profit margins improve and they increase supply.

→ SRAS slopes upward

SRAS shift factors:

Wage changes (wages rise → SRAS shifts left)
Input prices (oil price spike → SRAS shifts left)
Technological progress (SRAS shifts right)
Changes in expected inflation (higher expected inflation → SRAS shifts left)

Long-Run Aggregate Supply (LRAS)

In the long run, all prices adjust flexibly. The economy gravitates toward potential GDP (natural output).

→ LRAS is vertical (independent of the price level, vertical at potential GDP)

Potential GDP: The GDP producible at full employment (only frictional and structural unemployment remain).

LRAS Shift Factors

The LRAS shifts only when potential GDP itself changes:

Labor supply increases (population growth, immigration)
Capital accumulation
Technological progress
Institutional improvements (deregulation, stronger property rights)

Macroeconomic Equilibrium and Shock Analysis

Basic Equilibrium

Long-run equilibrium is reached where AD = SRAS = LRAS. At this point, the price level and real GDP are determined simultaneously.

Demand Shock Analysis

Positive demand shock (e.g., fiscal expansion, consumption boom):

AD shifts right
Short run: prices rise + GDP increases (new SRAS intersection)
Long run: wage negotiations push wages up → SRAS shifts left
Final outcome: GDP returns to its original level, but at a higher price level

Lesson: In the long run, demand expansion raises only prices; it does not increase real GDP.

Negative demand shock (e.g., financial crisis, consumption collapse):

AD shifts left
Short run: prices fall + GDP falls → recession
Long-run automatic adjustment: wages fall → SRAS shifts right → GDP recovers
However, Keynes argued: wage rigidity slows automatic adjustment → government intervention needed

Supply Shocks

Negative Supply Shock: Stagflation

Defining example: The 1973 and 1979 oil shocks

Crude oil price spike → production costs rise → SRAS shifts left → Prices rise + GDP falls → Stagflation

Why stagflation is so difficult: both inflation and unemployment are high. Expansionary policy raises inflation further; contractionary policy depresses GDP more. Standard demand-management tools cannot solve it.

Positive Supply Shock: Prosperity

Technological progress or falling input prices → SRAS shifts right → Prices fall + GDP rises → Ideal outcome

The US economy of the 1990s: IT-driven productivity gains → low inflation + strong growth achieved simultaneously.

The Keynesian vs. Classical Debate

Classical View

Prices are flexible → the economy quickly returns to potential GDP
Markets have self-correcting ability
Government intervention is unnecessary and counterproductive
“In the long run, the economy always finds equilibrium”

Keynesian View

Prices (especially wages) are sticky → automatic adjustment is slow
Recessions can be prolonged
Government fiscal policy must support AD
“In the long run, we are all dead” (Keynes)

Modern Synthesis (New Keynesian)

Short run: price stickiness → Keynesian analysis applies
Long run: converges to potential GDP → Classical analysis applies
Careful intervention required, accounting for policy lags and uncertainty

Inflation Expectations and the AS Curve

Expected inflation feeds back into actual prices.

Wage bargaining model: If workers expect next year’s inflation to be 5%, they demand at least a 5% wage increase. → Firms’ costs rise → SRAS shifts left → inflation is realized.

This is the self-fulfilling nature of inflation.

Why anchoring expectations matters:

Central bank credibility → stable inflation expectations → easier to control inflation
After Fed Chair Volcker’s high-rate policy in the early 1980s, expected inflation fell → low inflation was sustained for decades

Applying AD-AS to Recent US History

2020 COVID-19 Shock:

Consumption and investment collapsed → AD shifts left
Government response: fiscal expansion (stimulus checks, expanded unemployment insurance) → AD supported
Result: GDP decline was more modest compared with most advanced economies

2021–2022 Inflation Surge:

Supply chain disruptions (shipping, semiconductors) → SRAS shifts left
Pent-up consumer spending → AD shifts right
Russia-Ukraine war → energy costs → additional SRAS leftward shift
Result: sharp inflation spike → Fed began aggressive rate hikes in 2022

Learning Checklist

Explain the three reasons the AD curve slopes downward
Explain the difference between SRAS and LRAS
Explain the effects of demand and supply shocks using an AD-AS graph
Explain why stagflation is so difficult to resolve with standard policy
Explain the mechanism by which inflation expectations affect actual prices

Key Concept Cards

Money Supply and Monetary Aggregates ★★★★★ : Monetary base (MB) = currency + reserves. M1 = currency + demand deposits. M2 = M1 + savings deposits, money market funds, etc. Money multiplier = M1/MB = 1/(reserve ratio). Reserve ratio ↑ → money supply ↓. Memory tip: Reserve ratio = 10% → money multiplier = 10. Deposit $1,000 → up to$ 10,000 created

Fisher Equation and Quantity Theory of Money ★★★★ : MV = PQ (quantity theory). If V (velocity) and Q (real GDP) are fixed → M ↑ → P ↑ (inflation). Fisher equation: nominal interest rate = real interest rate + expected inflation.

Central Bank Monetary Policy Tools ★★★★★ : ① Open market operations (buy Treasuries → money supply ↑; sell → ↓): most important and frequent tool. ② Reserve requirement changes: higher reserve ratio → money supply ↓. ③ Discount rate: higher discount rate → bank lending ↓ → money supply ↓. Expansionary monetary policy: ① buy Treasuries + ② lower reserve ratio + ③ lower discount rate.

Practice Quiz

Q. What are the three expansionary monetary policy tools a central bank uses during a recession?

① Purchase government securities (open market) ② Lower reserve requirements ③ Lower the discount/policy rate → all three increase money supply, lower interest rates, and stimulate consumption and investment.

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