AD/ AS Model

Model that describes long run and short run economic changes trough AD and AS. It is a model of Business Fluctuations, so fluctuations in real GDP around its long term trend or nominal growth rate.

1. Aggregated Demand: All possible combinations of inflation and real GDP growth rate

   Spending Growth (MV) = Inflation + Real Growth

2. Long Run Aggregate Supply: Economy has a potential growth rate depending on Productivity (Technology, Labour, Capital) —> Does not depend on Inflation

3. Short run Aggregate Supply: Economists believe that in the short run, an increase in spending growth does not directly change inflation, as prices, especially wages, are sticky

• AD Shock: Shift AD Curve (higher consumption)

• Real Shock: Affecting productivity in a country, e.g. weather, wars, tax changes,

• Money supply —> AD shifts to right

• Consumer buy more bread in a bakery

• Higher Inflation and higher growth rate (in short run)

• Bakers bake more, might even work more hours or hire more workers

• But after a while, they realise that Inflation increased and is more then expected

• Prices, for workers or ingredients rise, so baker also rises the price of bread

• When the price of bread rises; SRAS shifts to the left

• New Equilibrium with higher inflation rate but initial growth rate

• Change in AD does not change the fundamental factors of groth

• Government can change by increasing its defense spending

• However, in the long run, government spending can not change faster than the economy grows

• AD goes back