Aggregate Demand and Aggregate Supply Model (AD-AS)
The equilibrium of supply and demand in the national economy is reached at the intersection of the aggregate demand and aggregate supply curves (Figure 8.2).
Suppose the price level is P1. At this level, supply would be Q1 and demand would be Q2. Since demand exceeds supply, competition will begin between buyers, and it will raise the price to the level of Pe. Higher prices will stimulate the production of the national product, and its supply will rise to the level of Qe. In turn, consumers will reduce demand to the value of Qe. Macroeconomic equilibrium will come.
It is possible that the aggregate demand curve crosses the aggregate supply curve in a horizontal (Keynesian) segment (Figure 8.3).
Macroeconomic equilibrium here will come at point E. It corresponds to the supply of Qe and the price level pe. Suppose that the national economy produced the national product in the amount of Q2, and the demand is equal to Qe. It is smaller than the supply and does not allow you to buy the entire national product. An excess of product is formed, and enterprises reduce output to the equilibrium size of Qe. If enterprises produce a national product in the amount of Q1, then the aggregate demand for Qe exceeds supply and therefore the production of the national product increases to Qe.
Let us consider how changes in aggregate demand and aggregate supply will affect macroeconomic equilibrium (and hence the volume of national production, employment and the price level). If demand grows, then in different parts of the aggregate supply curve, the macroeconomic equilibrium will be as follows (Fig. 8.4).
On the horizontal stretch, an increase in aggregate demand from ADl to AD2 will lead to an increase in employment and an increase in the volume of national product from Q1 to Q2, without an increase in prices. In the ascending period, an increase in aggregate demand from AD2 to AD3 will lead to an increase in the production of the national product from Q2 to Q3 and an increase in prices to P3, as employment grows and unused capacities begin to be used. The increase in demand on the classic (vertical) segment from AD4 to AD5 will only have an impact on the price level, raising them from P4 to P5, since here the production capacity and labor force are fully used.
What happens if aggregate demand declines? In the Keynesian segment, the volume of the national product produced will decrease, and the price level will remain constant. In the vertical (classical) segment, prices will decrease, and the volume of the national product will not change. In the ascending period, both the price level and the value of the national product decrease (Fig. 8.4).
However, if demand decreases from AD5 to AD4 or from AD5 to AD2, the original equilibrium will not be restored. This is due to the inadequate reaction of prices to changes in demand: a decrease in demand to the initial level is not accompanied by the same decline in prices. They remain at a higher level than before. The reasons for this trend lie in the policy of monopolistic firms that do not reduce their prices, as well as in maintaining the previous level of wages, which make up a significant part of the costs of firms. (Wages cannot be reduced automatically because of collective agreements, which are usually concluded for several years.) This phenomenon is called the “ratchet effect”. Just as the ratchet spins the wheel only forward, so macroeconomic equilibrium is constantly restored at a higher price level.
It should be noted that sometimes abrupt changes in aggregate supply and demand — shocks — lead to a deviation in output and employment from potential levels. Demand shocks can occur, for example, due to a sharp change in the supply of money or the speed of their circulation, sharp fluctuations in investment demand, etc. Supply shocks can be associated with sharp jumps in resource prices (price shocks, for example, an oil shock), with natural disasters leading to the loss of part of the resources of the economy and a possible decrease in potential, increased activity of trade unions, changes in legislation and, for example, the associated significant increase in environmental costs, etc.
Using the AD-AS model, it is possible to assess the impact of shocks on the economy, as well as the consequences of the state’s stabilization policy aimed at mitigating fluctuations caused by shocks and restoring equilibrium output and employment to previous levels.
For example, a negative supply shock (rising oil prices) causes an increase in the general price level (the short-term AS curve shifts upwards from SRAS1 to SRAS2) and a drop in output (point B) (Figure 8.5). SRAS is a short ran aggregate supply curve.
If the government and the central bank do not take any steps, the economy will adapt to the new situation. With the level of production and employment below the potential (point B), prices will begin to gradually decline, and the level of employment and output will return to their previous state. This will be reflected in the graph by the reverse movement along the previous AD1 curve from point B to point A. However, such a process of adaptation can be very long, and a protracted recession in the economy is fraught with social conflicts.
A central bank can neutralize the downturn by increasing the money supply (shifting the AD curve from AD1 to AD2 to the right), but the consequence of this will be fixing prices at a higher level established as a result of the shock (point C). A similar result is achieved by increasing public spending. Thus, the economic policy of the state faces a well-known dilemma: a prolonged recession and unemployment or rising prices while maintaining the level of employment and output.
There are other representations of the AD-AS model in the literature. If it is necessary to focus not on the temporal aspect of the analysis, but on the proximity of the economy to the potential, use the curved shape of the AS curve, where its Keynesian and classical segments are combined (Fig. 8.6). Sometimes an “average” variant is used when the AS curve has a positive slope, which is convenient, for example, to illustrate the “inflationary spiral” and distinguish between demand inflation and cost inflation (Figure 8.7).
For example, in an economy close to full employment, the growth in aggregate demand caused by an increase in the supply of money (AD1 → AD2) will not only increase the volume of output for a while, but under certain circumstances can lead to demand inflation, the price level will rise to P2. Against this background, in conditions of almost full use of available resources, their prices will begin to rise, which will increase costs and cause a decrease in aggregate supply (shift of the AS curve from AS1 to AS2). Movement along the AD2 curve from point B to point C reflects cost inflation, the price level rises to P3, and the output level returns to its original state (movement along AD2 also means a drop in aggregate demand against the background of rising prices). A repetition of attempts at monetary influence on aggregate demand will lead to a similar result and will further raise the price level. A long-term sustainable equilibrium will be established at the level of potential Y*.