Question

What is the steady state and how it is determined in AS-AD model?

Answer 1

Steady state is defined as any situation that remians constant or unchanged even after some kind of transformation or change has taken place. In economics, it's made up of constant stock of physical captial and constant population size. It focuses on finding an equilibrium between production growth and population growth.

How is it determined AS-AD model?

To understand this, let's take an example of inflation shock.

Let's assume that the economy begins at the level of steady state and then policymakers decide to lower the target rate they have set for inflation. This will lead to AD curve shifting down because due to increased inflation rate,output level that is associated with the policy reduced. Now according to the principle of transition dynamics, the economy moves to its level of steady state. This change in the inflation rate leads to shift in the AS curve. Firms thus adjust their expectations for inflation to account for the new lower inflation rate and this will lead to the AS curve shifting downwards. Eventually, the economy will rest in its steady state.