CHAPTER 7: ECONOMY IN THE

SHORT RUN: THE AD-AS

MODEL
THE AD-AS MODEL
 The aggregate demand and aggregate supply model is
developed to explain the short run fluctuations in economic
activity.
 Two variables are used to develop a model to analyze the
short run fluctuations.
 The economy’s output of goods and services measured by real
GDP.
 The price level measured by the CPI or the GDP deflator.
 The AD-AS model helps to explain changes in the economy’s
output as well as the price level.
AGGREGATE DEMAND
 An aggregate demand curve shows the relationship
between the total output and price level that exists when
there is simultaneous equilibrium in the money and
goods markets.
DERIVING THE AD CURVE
LM2
At price P = P1, real money supply is r
MS/P1 and the LM curve is LM1. The E2 LM1
equilibrium output is Y1. r2
E1
A (P1,Y1) belong to the AD curve. r1
At a higher price P = P2, real money IS
supply MS/P2 decreases and causes the
LM curve to shift to the left. The Y2 Y1 Y
P
equilibrium output is Y2.
B
B (P2,Y2) belong to the AD curve. P2
The AD curve is downward sloping P1 A
that shows a negative relationship
between the price level and the total AD
output.
Y2 Y1 Y
SHIFTS IN THE AD CURVE
 The aggregate demand curve shifts when there is a
change in any factor (other than price) that causes a
change in IS or LM curve.
 Examples: There is a change in
 Consumption
 Investment
 Government spending
 Taxes or subsidies
 Net exports
 Nominal money supply 
 Demand for money    
SHIFTING THE AD CURVE: CHANGE IN GOVERNMENT
SPENDING
r LM
At each price level E2
r2
G   IS curve shifts right E1
r1 IS2
 Y
IS1
… so the AD curve shifts to the
right. Y1 Y2 Y
P

A B
P1

AD2
AD1
Y1 Y2 Y
SHIFTING THE AD CURVE: CHANGE IN MONEY SUPPLY
LM1(MS1)
r
At each price level: E1 LM2(MS2)
r1
MS ↑  LM curve E2
r2
shifts right
IS
 r↓
Y1 Y2 Y
 I↑ P

 Y↑ P1
A B

… so the AD curve shifts to AD2

the right. AD1
Y1 Y2 Y
SHIFTS IN THE AD CURVE
 The AD curve shifts to the right when
 The IS curve shifts to the right: there is an increase in
consumption, investment, government spending, subsidies,
export or a decrease in taxes, import.
 The LM curve shifts to the right: there is an increase in the
nominal money supply.
 The AD curve shifts to the left when
 The IS curve shifts to the left: there is a decrease in
consumption, investment, government spending, subsidies,
export or an increase in taxes, import.
 The LM curve shifts to the left: there is a decrease in the
nominal money supply.
AGGREGATE SUPPLY
 In the long run, the economy produces at the full
employment output (the natural rate of output).
 The long run AS curve is vertical line at the full
employment output.
 The price level does not affect the total output of goods
and services produced and supplied.
AGGREGATE SUPPLY
 In the short run, the output that the economy produces
deviates from its natural rate.
 The short run AS curve is upward sloping.
 The price level has a positive effect on the total output of
goods and services produced and supplied.
THE AS CURVE
 The equation for the long run AS curve

𝑌 =𝑌
 The equation for the short run AS curve

¿
Where Y: the total output
: the natural rate of output
P : the price level
: the expected price level
LONG RUN AGGREGATE SUPPLY CURVE

P LRAS
 The equation for the
long run AS curve

Y
SHORT RUN AGGREGATE SUPPLY
CURVE

P
 The equation for the short SRAS
run AS curve B
P1
¿ e A
P
 If P = then Y =
C
 If P > then Y > P2
 If P < then Y <

Y
Y2 Y Y1
SHIFTS IN THE AS CURVE
 Long run aggregate supply curve shifts when there is a
change in
 Labor
 Capital
 Naturalresources
 Technology
SHIFTS IN THE AS CURVE
 Long run AS curve shifts to the right when there is an
increase in stock of labor, capital, natural resources or
advanced technology.
 Long run AS curve shifts to the left when there is a
decrease in stock of labor, capital, natural resources or
obsolescent technology.
SHIFTS IN THE AS CURVE
 Short run aggregate supply curve shifts when there is a
change in
 Labor
 Capital
 Natural resources
 Technology
 Expected price level
 Per unit cost of production
SHIFTS IN THE AS CURVE
 Short run AS curve shifts to the right when there is an
increase in stock of labor, capital, natural resources,
advanced technology or a decrease in expected price
level or per unit cost of production.
 Short run AS curve shifts to the left when there is a
decrease in stock of labor, capital, natural resources,
obsolescent technology or an increase in expected price
level or per unit cost of production.
AD-AS MODEL
 The economy establishes a long run equilibrium at the
intersection of the AD and long run AS curves.
 Long run equilibrium determines the price level in the long
run while total output at the natural rate of output.
 The economy establishes a short run equilibrium at the
intersection of the AD and short run AS curves.
 Short run equilibrium determines total output and price
level in the short run.
AD-AS MODEL: LONG RUN EQUILIBRIUM

AS
Long run
P
equilibrium
determines the
price level in the
long run while PE E
total output at the
natural rate of
output.
AD

YN Y
AD-AS MODEL: SHORT RUN EQUILIBRIUM

P AS
Short run
equilibrium
determines total
output and price
PE E
level in the short
run.

AD

YE Y
EXPLAINING SHORT RUN ECONOMIC
FLUCTUATIONS
 Economic fluctuations refer to changes in total output and
other macroeconomic variables in the economy in the short
run.
 Short run economic fluctuations occur when there is a
change in
 aggregate demand
 aggregate supply
 or both.
 Any change in economic conditions affecting aggregate
demand or aggregate supply or both will lead to economic
fluctuations in the short run.
EXPLAINING SHORT RUN ECONOMIC
FLUCTUATIONS
 Aggregate demand shocks: changes in the components of
aggregate demand → AD curve shifts.
 Examples: changes in
 Household consumption behavior
 Firms’ investment behavior
 Fiscal policy: changes in G or T
 Monetary policy: changes in nominal money supply
 Trade policy
…
SHORT RUN ECONOMIC FLUCTUATIONS: AGGREGATE
DEMAND SHOCK

Initially the economy is at equilibrium E1

P = P1 ; Y = Y1 P
Event: Firms are optimistic  about future AS1
economic condition and invest more → the IS
curve shifts to right → Aggregate demand
increases, and aggregate demand curve shifts P2 E2
E1
to the right.
P1
The economy reaches the new equilibrium at
E2
AD2
P = P2 ; Y = Y2
AD1
P2 > P1 : Price level increases
Y2 > Y1 : Total output increases Y1 Y2 Y
Conclusion: Price level and total output
increase.
EXPLAINING SHORT RUN ECONOMIC
FLUCTUATIONS
 Aggregate supply shocks: changes that affect the
production and supply of goods and services in the
economy → aggregate supply curve shifts.
 Examples: changes in
 Economic resources
 Prices of inputs
 Tax policy: business taxes
 Technological progress
…
SHORT RUN ECONOMIC FLUCTUATIONS: AGGREGATE
SUPPLY SHOCK

Initially the economy is at equilibrium E1

P = P1 ; Y = Y1 P
AS1
Event: Advanced technology is used in
production→ Aggregate supply increases and AS2
aggregate supply curve shifts to the right.
E1
The economy reaches the new equilibrium at P1
E2
P2 E2
P = P2 ; Y = Y2
P2 < P1 : Price level decreases AD1
Y2 > Y1 : Total output increases
Conclusion: Price level decreases and total Y1 Y2 Y
output increases.
INFLATION, UNEMPLOYMENT AND THE
PHILLIPS CURVE
 The Phillips curve shows the relationship between inflation
and unemployment.
 The AS curve equation

Y  Y   P  P e 
P  P e  (1 /  )Y  Y 
 Deduct the previous year price level from both sides
P  P1  P  P1   (1 /  )Y  Y 
e

 The Phillips curve equation

   e   u  u n   
ADAPTIVE EXPECTATIONS AND
INFLATION INERTIA
 People form their expectations of inflation based on
recently observed inflation. This assumption is called
adaptive expectations.
 Example: people expect the price level to rise this year at
the same rate in last year.
 e   1
 The Phillips curve is written as:

   1   u  u   n
INFLATION, UNEMPLOYMENT AND THE
PHILLIPS CURVE
 Inflation depends on past inflation, cyclical unemployment
and a supply shock.
 Inflation has inertia: past inflation affects inflation in future.
 There is a short run trade off between inflation and
unemployment: low unemployment accompanies with high
inflation and vice versa (demand pull inflation).
 Negative or positive supply shock causes inflation to increase
or decrease (cost push inflation).
SHORT RUN TRADEOFF BETWEEN
INFLATION AND UNEMPLOYMENT
 The short run Phillips curve shows a tradeoff relation
between inflation and unemployment.
 Increase in aggregate demand results in a higher total output, a lower
unemployment rate but inflation rate increases.
 Decrease in aggregate demand results in a lower total output, a
higher unemployment rate but inflation rate decreases.
 The sacrifice ratio measures the percentage of real GDP that
must be forgone to reduce inflation by 1 percentage point.
 Example: the sacrifice ratio is 5 means that reducing inflation by 1
percentage point requires a sacrifice of 5% of GDP.