Question

1) What are the components of the AD-AS model? and how are they anakyzed?

2) How do you calculate RGDP from NGDP using information from a graph?

3) Explain the difference between a movement along the AD, the SRAS or the LRAS curves. What causes shifts of these curves?

Answer 1

(1)

The AD/AS model is used to illustrate the Keynesian model of the business cycle. Movements of the two curves can be used to predict the effects that various exogenous events will have on two variables: real GDP and the price level. Furthermore, the model can be incorporated as a component in any of a variety of dynamic models (models of how variables like the price level and others evolve over time). The AD–AS model can be related to the Phillips curve model of wage or price inflation and unemployment. A special case is a horizontal AS curve which means the price level is constant. The AD curve represents the locus of equilibria in the IS–LM model. The two models produce the same results with a constant price level.

The AD/AS model allows economists to analyze multiple economic factors.

Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts including the three macroeconomic goals of growth, low inflation, and low unemployment; the elements of aggregate demand; aggregate supply; and a wide array of economic events and policy decisions.

The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing these factors together in one diagram. In addition, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach—focusing on aggregate demand and the short run—while also including the Say’s law approach—focusing on aggregate supply and the long run.

(2)

Gross Domestic Product

The Gross domestic Product (GDP) is the market value of all final goods and services produced within a country in a given period of time. The GDP is the officially recognized totals. The following equation is used to calculate the GDP:

GDP=C+I+G+(X−M)GDP=C+I+G+(X−M)

Written out, the equation for calculating GDP is:

GDP = private consumption + gross investment + government investment + government spending + (exports – imports).

For the gross domestic product, “gross” means that the GDP measures production regardless of the various uses to which the product can be put. Production can be used for immediate consumption, for investment into fixed assets or inventories, or for replacing fixed assets that have depreciated. “Domestic” means that the measurement of GDP contains only products from within its borders.

Nominal GDP

The nominal GDP is the value of all the final goods and services that an economy produced during a given year. It is calculated by using the prices that are current in the year in which the output is produced. In economics, a nominal value is expressed in monetary terms. For example, a nominal value can change due to shifts in quantity and price. The nominal GDP takes into account all of the changes that occurred for all goods and services produced during a given year. If prices change from one period to the next and the output does not change, the nominal GDP would change even though the output remained constant.

Nominal GDP: This image shows the nominal GDP for a given year in the United States.

Real GDP

The real GDP is the total value of all of the final goods and services that an economy produces during a given year, accounting for inflation. It is calculated using the prices of a selected base year. To calculate Real GDP, you must determine how much GDP has been changed by inflation since the base year, and divide out the inflation each year. Real GDP, therefore, accounts for the fact that if prices change but output doesn’t, nominal GDP would change.

Real GDP Growth: This graph shows the real GDP growth over a specific period of time.

In economics, real value is not influenced by changes in price, it is only impacted by changes in quantity. Real values measure the purchasing power net of any price changes over time. The real GDP determines the purchasing power net of price changes for a given year. Real GDP accounts for inflation and deflation. It transforms the money-value measure, nominal GDP, into an index for quantity of total output.

(3)

Introduction

the aggregate demand is made up of four components: consumption spending, investment spending, government spending, and spending on exports minus imports.Increasing any of these components shifts the AD curve to the right, leading to a greater real GDP and to upward pressure on the price level. Decreasing any of the components shifts the AD curve to the left, leading to a lower real GDP and a lower price level.

Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve happens in the relatively flat or relatively steep portion of the short-range aggregate supply, or SRAS, curve.

In this article, we'll discuss two broad categories that can cause AD curves to shift—changes in the behavior of consumers or firms and changes in government tax or spending policy.

How do changes by consumers and firms affect AD?

When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. On the other hand, if consumer or business confidence drops, then consumption and investment spending decline.

Because a rise in confidence is associated with higher consumption and investment demand, it leads to an rightward shift in the AD curve. If you'll look at Diagram A, on the left below, you'll see that this shift right moves the equilibrium from {E0}, to {E1} a higher quantity of output and a higher price level.

Shifts in aggregate demand

The two graphs show how aggregate demand shifts. The graph on the left shows aggregate demand shifting to the right toward the vertical potential GDP line. The graph on the right shows aggregate demand shifting to the left away from the vertical GDP line.

Consumer and business confidence often reflect macroeconomic realities. For example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall due to factors that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure.

US presidents, for example, must be careful in their public pronouncements about the economy. If a president makes pessimistic statements about the economy, they risk provoking a decline in confidence that reduces consumption and investment, shifting AD to the left and causing the recession that the president warned against in the first place. You can see what this scenario would look like graphically in Diagram B, on the right above. A shift of AD to the left moves the equilibrium from E0 to t{E1} a lower quantity of output and a lower price level.

Government macroeconomic policy choices can shift AD.

Because the government has influence over several of the components of aggregate demand, it has the power to shift AD through its policy choices.

Take, for example, government spending—one component of AD. Higher government spending causes AD to shift to the right—see Diagram A, on the left above—while lower government spending will cause AD to shift to the left—see Diagram B, on the right above.

Tax policy can affect consumption and investment spending as well. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Since both consumption and investment are components of aggregate demand, changing either will shift the AD curve as a whole.

During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the US Congress often passes tax cuts. During the recession of 2001, for example, a tax cut was enacted into law. At such times, the political rhetoric often focuses on how people going through hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale.

Let's examine the situation graphically using the AD/AS model below. The original equilibrium during the recession is at point {E0}, relatively far from the full-employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium {E1} real GDP rises and unemployment falls and—because in this diagram the economy has not yet reached its potential or full-employment level of GDP—any rise in the price level remains muted.

Recession and full employment in the AD/AS model

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.

Other policy tools can shift the aggregate demand curve as well. 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.