Question

Aggregate Supply (AS) and Aggregate Demand (AD) model and AS/AD curves are essential to understand macroeconomic fluctuations (business cycles).

1. Discuss the importance AS-AD model in explaining the macroeconomic conditions of the economy and business cycles like recessions.
2. What factors shift AS and AD curves? How do you explain macroeconomic fluctuations using AS-AD model and AS/AD curves?

Answer 1

1. Business Cycles represent the growth and decline of the economy. There are 4 phases : Expansion, Peak, Recession and trough.

The AS-AD model can be used to understand the expansion and recession stages.

Recession are a result of supply shock or lack of demand. Due to this, the equilibrium level of GDP falls below the potential GDP.

As you can see the above graph ( left ) , a shortage in demand has caused the AD curve to shift leftwards and thus output level falling from Y₀ to Y₁ .

Similarly a supply shock will shift the supply curve leftwards and bring down the output level.

Falling if output level or GDP marks the recession phase.

Similarly , the rightwards shift of supply or demand curve will increase the output level.

So, a continuous leftward shifts or rightward shifts represents the recession and growth phase respectively.

2. Recession can be caused due to negative effects on AD or AS

A) Fall in consumer spending due to higher taxes or decrease in government spending ( leftward shift of AD)

B) Increase in cost of necessary inputs for the production ( leftward shift of AS)

Expansion can be caused due to positive effects on AD or AS

A) Decrease in taxes and increase in consumer spending, increase in government expenditure, increase in business confidence ( rightward shift of AD)

B) Fall in the prices of inputs , better production technology to reduce cost of production ( rightward shift of AS )