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AD–AS model - Wikipedia

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Therefore, this is consistent with the AD-AS diagram below. us good reason to suspect that Consumptions follows a relationship like: Original AE Model. N*. The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of. The equation for aggregate expenditure is: AE = C + I + G + NX. . The AD-AS model is used to graph the aggregate expenditure at the point of In economics, the fiscal multiplier is the ratio of change in the national income in relation to the.

How the AD/AS model incorporates growth, unemployment, and inflation

The graph shows an example of an aggregate demand shift. The higher of the two aggregate demand curves is closer to the vertical potential GDP line and hence represents an economy with a low unemployment.

In contrast, the lower aggregate demand curve is much farther from the potential GDP line and hence represents an economy that may be struggling with a recession.

For example, the Federal Reserve can affect interest rates and the availability of credit. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by businesses.

On the other hand, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.

relationship ad and ae

The aggregate demand curve shifts to the right as the components of aggregate demand—consumption spending, investment spending, government spending, and spending on exports minus imports—rise. The AD curve will shift back to the left as these components fall. AD components can change because of different personal choices—like those resulting from consumer or business confidence—or from policy choices like changes in government spending and taxes.

If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall. Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.

Self-check questions How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?

An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending, shifting the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level.

Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession.

Shifts in aggregate demand

This decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level.

A policymaker claims that tax cuts led the economy out of a recession. Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. This would shift AD to the right. What would be the effects of negative reports on both of these?

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What about positive reports? A negative report on home prices would make consumers feel like the value of their homes—which for most Americans is a major portion of their wealth—has declined. A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level. A positive report on the home price index or consumer confidence would do the opposite. Review questions Name some factors that could cause AD to shift, and explain whether they would shift AD to the right or to the left.

Would a shift of AD to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of AD to the left? Also, the AD curve is flatter, the larger is the multiplier and the larger the income responsiveness of the demand for money. Effect of monetary expansion on the AD curve[ edit ] Aggregate demand curve shifts rightward in case of a monetary expansion An increase in the nominal money stock leads to a higher real money stock at each level of prices.

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In the asset market, the decrease in interest rates induces the public to hold higher real balances. It stimulates the aggregate demand and thereby increases the equilibrium level of income and spending.

Thus, as we can see from the diagram, the aggregate demand curve shifts rightward in case of a monetary expansion. Aggregate supply curve[ edit ] Main article: Aggregate supply The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium. In either case, it shows how much output is supplied by firms at various potential price levels.

The aggregate supply curve AS curve describes for each given price level, the quantity of output the firms plan to supply.

The Keynesian aggregate supply curve shows that the AS curve is significantly horizontal implying that the firm will supply whatever amount of goods is demanded at a particular price level during an economic depression.

The idea behind that is because there is unemployment, firms can readily obtain as much labour as they want at that current wage and production can increase without any additional costs e.

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Firms' average costs of production therefore are assumed not to change as their output level changes. This provides a rationale for Keynesians' support for government intervention. The total output of an economy can decline without the price level declining; this fact, in conjunction with the Keynesian belief of wages being inflexible downwards, clarifies the need for government stimulus.

Since wages cannot readily adjust low enough for aggregate supply to shift outward and improve total output, the government must intervene to accomplish this result. However, the Keynesian aggregate supply curve also contains a normally upward-sloping region where aggregate supply responds accordingly to changes in price level.

The upward slope is due to the law of diminishing returns as firms increase output, which states that it will become marginally more expensive to accomplish the same level of improvement in productive capacity as firms grow. It is also due to the scarcity of natural resources, the rarity of which causes increased production to also become more expensive. The vertical section of the Keynesian curve corresponds to the physical limit of the economy, where it is impossible to increase output.

The classical aggregate supply curve comprises a short-run aggregate supply curve and a vertical long-run aggregate supply curve.

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The short-run curve visualizes the total planned output of goods and services in the economy at a particular price level. The "short-run" is defined as the period during which only final good prices adjust and factor, or input, costs do not.

The "long-run" is the period after which factor prices are able to adjust accordingly. The short-run aggregate supply curve has an upward slope for the same reasons the Keynesian AS curve has one: The long-run aggregate supply curve is vertical because factor prices will have adjusted.

Factor prices increase if producing at a point beyond full employment output, shifting the short-run aggregate supply inwards so equilibrium occurs somewhere along full employment output. Monetarists have argued that demand-side expansionary policies favoured by Keynesian economists are solely inflationary. As the aggregate demand curve is shifted outward, the general price level increases.