AD AS model: All the things you need to know

What is AD-AS model?

AD-AS model (aggregate demand and aggregate supply model) explains how national income and general price level are changed together.

In an ad as model, what are ad and as?

AD-AS model is an model comprised with aggregate demand (AD) and aggregate supply (AS) curves.

The aggregate demand and aggregate supply model explains the marketplace for all goods and services in the whole economy.

What does the AD-AS model explain?

AD-AS model (aggregate demand and aggregate supply model) explains how national income and general price level are changed together. So, we can use AD-AS model to illustrate the changes of the macroeconomic variables such as real GDP, Inflation, unemployment and to illustrate the phrases of the business cycle.

An economy can depart from its equilibrium level of output at any time. Multiple factors might cause an economy to momentarily deviate from its equilibrium output; however, all of these fluctuations have one thing in common: they occur in either the aggregate demand or aggregate supply curve.

AD AS Curve (Aggregate demand and aggregate supply graph)

AD AS curve (in other words, aggregate demand and aggregate supply graph) is comprised with three curves. They are,

1. Aggregate demand (AD) curve

2. Short-run aggregate supply (SRAS) curve

3. Long-run aggregate supply (LRAS) curve

What are the three components of the AD-AS model?

In above graph, notice three important curves. These three curves shows the three components of the AD-AS model. They are,

1. Aggregate demand (AD)

2. Short-run aggregate supply (SRAS)

3. Long-run aggregate supply (LRAS)

Let’s discuss about them.

Aggregate demand (AD)

Aggregate demand means in a specific time period, total demand for final goods and services which are produced within a particular economy.

what shifts the ad curve?

There are four components in the aggregate demand. These components also considered as shifters of ad. They are private consumption, gross investment, government expenditure and net exports. So for an economy aggregate demand equals,

Aggregate Demand = Private consumption + Gross investment + Government expenditure + Net exports.

An event capable of shifting the aggregate demand curve is known as a demand shock. If any of these shifters of ad (private consumption, gross investment, government expenditure and net exports) is decreased, aggregate demand will shift to the left (negative demand shock). On the other hand, if any of these shifters of ad increased, aggregate supply will shift to the right (positive demand shock).

The downward slope of the aggregate demand (AD) curve shows that “there is an inverse relationship between the demand for real GDP level and general price level of an economy”.

This is explained by the wealth effect (assets purchase fewer real products as prices rise), the interest rate effect (higher prices correlate to higher nominal interest rates, which correlate to less gross investment), and the net export effect (higher price levels mean fewer exports).

Short-run aggregate supply (SRAS)

Aggregate supply means in a specific time period, total supply for final goods and services which are produced within a particular economy. There are many factors impact the short run aggregate supply of an economy. These factors can shift the aggregate supply curve in other words these factors can create supply shocks.

So, we can identify three major factors impact short-run aggregate supply (shifters of as) as follows.

Commodity prices

Commodity prices is one of the main shifters of as. Higher commodity prices shift the aggregate supply curve to the leftward. Because commodities are used as an inputs of the production process. So that increasing commodity prices means increasing cost of the production.

Nominal wages

Nominal wages is one of the main shifters of as. Higher nominal wages shift the aggregate supply curve to the leftward. Because commodities are used as an input of the production process. So that increasing nominal wages mean increasing cost of the production.

Productivity

Productivity is one of the main shifters of as. Higher productivity shifts the aggregate supply curve to the rightward. Because when productivity is increased, a labour can produce more units of output.

The upward slope of the aggregate supply (AS) curve shows that “there is a positive relationship between the supply for real GDP level and general price level of an economy”. That means when price is increasing, aggregate supply will be increased. This curve is upward sloping as resource prices are sticky in the short run (they do not immediately adjust to new price levels).

When price levels rise from a leftward shift of the SRAS, it is called “cost push inflation,” or “stagflation” which means there is a recession and inflation at the same time.

Long-run aggregate supply (LRAS)

Long run aggregate supply is a vertical line and it shows the real full employment output level of the economy. It is vertical because, in the long run, wages and resource prices are flexible and adjust to the price level. The LRAS curve is also called potential output, because it is considered the economy’s capacity. It shows the aggregate output level of the economy when using the entire level resources. In other words, long-run aggregate supply (LRAS) presented the output level that corporate with natural rate of unemployment or zero cyclical unemployment.

LRAS is changed by the any factor that shifts the production possibility of the economy. As examples for shifters of as in long run we can say quantity and quality of the resources, technology.

AD-AS model – short run equilibrium

Short run equilibrium of an economy is the point where aggregate demand equals to the short run aggregate supply. So, in the AD-AS model, you can find the short-run equilibrium by finding the point where AD intersects SRAS. This short run equilibrium point can be changed by the any factor that shift the AD curve and SRAS curve as mentioned in above. Short run equilibrium level can be occurred even though economy is in the full employment output level, inflationary gap or recessionary gap.

Inflationary gap

The inflationary gap measures the amount of actual GDP exceeding the potential GDP level of the economy. In other words, the inflationary gap is a macroeconomic theory to determine the positive difference between the current level of real gross domestic product (GDP) and the full employment level GDP of the economy.

Recessionary gap

The recessionary gap is the negative gap between the actual GDP level and the potential GDP level of the economy. In other words, the recessionary gap measures the amount of actual GDP less than the potential GDP level of the economy.

AD-AS model – long run equilibrium

Long run equilibrium of an economy is the point where aggregate demand, short run aggregate supply and long run aggregate supply equals to each other. This is the full employment output level of the economy. So, there is no inflationary gap or deflationary gap. The long run equilibrium is changed as a result of changing the long run aggregate supply.

Long run equilibrium output level is also called as potential GDP. Potential GDP is the level of gross domestic product (GDP) that the economy able to achieve by operating at a full employment output level. So, potential GDP presents the output level that maximum using the resources within the productive capacity, especially at a constant inflation rate.

AD AS full employment graph

AD AS full employment graph shows the long run equilibrium output level (Yf output level in the following graph) of an economy.

Economic Growth, Recession & Inflation in AD-AS Model

Economic growth in AD-AS model

Long-run economic growth can be achieved through an increase of productivity. When productivity is increasing, the short-run aggregate supply curve shifts to rightward. Continued increase of productivity may lead to the rightward shift of the long-run aggregate supply curve (rightward shift of the full employment level of the economy).

Economic growth is shown in the as-ad model as a rightward shift of the short run aggregate supply curve and long run aggregate supply curve (LRAS).

The following graph shows how the economy has grown for three years. In this economy, the short-run aggregate supply curve (SRAS) has shifted to rightward from SRAS0 to SRAS1 and to SRAS2 as a result of the productivity increase. Long-run aggregate supply (full employment output level) has increased from LRAS0 to LRAS1 and to LRAS2.

Nevertheless, the variables that affect how fast this long-term economic growth rate grows such as investments in physical and human capital, technology, and whether a country may benefit from catch-up growth are not readily visible in an AD/AS diagram.

So, economic growth is shown in the as-ad model as a rightward shift of the short run aggregate supply curve and long run aggregate supply curve (LRAS).

Recession in AD AS model

What is a recession?

Recession means a period of negative or very weak economic growth.

It is very important to define recession technically. When we technically define the recession, “it is the period of minimum two consecutive quarters of negative economic growth rate”. Here usually economic growth is determined by the growth of the Gross Domestic Product (GDP).

But some well-reputed organizations have defined the recession differently. As an example, according to the National Bureau of Economic Research (NBER), recession means a period of minimum of more than a few consecutive months with significant economic decline.

You may be interested to read more about,

Recession Vs Depression: Differences & Examples

Inflation Vs Recession: Definitions, differences, and relationship

How does a recession affect me?

13 recession proof jobs for the coming recession

Top 10 recession proof businesses for you

Are we in a recession & when will recession end?

When an economy with a recession, its aggregate production is declined or increased very slowly, and unemployment is increased significantly. Because the output level of the business organizations is decreased and then they have to lay off employees. As result of losing employment, people reduce their private consumption expenditures such as buying a car, or house.

AD AS recession graph

What happens to AD-AS model in recession?

According to the AD AS model, recession is presented left to the full employment output level. Because, in a recession, actual output is lower than the full employment output level.

In following ad as graph, any output level that is lower than the full employment (Yf) output level, is considered as an output level with the recession. As examples, if economy is at Y2 output level, there is a recession.

As mentioned in the AD-AS model, a recession is created by the leftward shift of the aggregate demand curve and the leftward shift of the short-run aggregate supply curve.

We will discuss them more clearly.

1. Decrease in the aggregate demand

A lower level of aggregate demand can occur as a result of decreasing private consumption, decreasing private investment, decreasing government expenditure, and decreasing net exports.

In above ad as graph, at Yf (full employment) output level, there is no recession or inflation. After that, aggregate demand has been decreased (AD curve has shifted from AD1 to AD2). The economy has moved to a temporary recession. Now equilibrium price is P2 and equilibrium output leve is Y2. At this output level, AD=SRAS but it is lower than LRAS.

2. Decrease in the aggregate supply.

When nominal wages are increased and input prices are increased, economy decreases the resource usage. They will discourage the short-run aggregate supply. This can create a recessionary gap.

Inflation in AD AS model

What is Inflation?

Inflation can be defined as the increase in the general price level of goods and services. Inflation occurs as a result of different social, economic, and political factors. There are three types of inflation. They are demand-pull inflation, cost-push inflation, and built-in inflation.

Three types of inflation

1. Demand-pull inflation

Demand-pull inflation describes that increasing demand for goods and services increases the price level.

2. Cost-push inflation

As a result of the cost of materials and the cost of wages increasing, cost-push inflation occurs. Cost-push inflation often kicks in when demand-pull inflation is going strong.

3. Built-in inflation

As employees expect an increase in income when the cost of goods and services rises in order to maintain their standard of living, this is known as built-in inflation.

How does inflation affect the AD-AS model?

According to the AD-AS framework, there are two major ways that the inflation can rise.

1. Rightward shift of the aggregate demand curve

The first one is continuous rightward shift of the aggregate demand curve when economy is already near to the full employment output level. As mentioned in the below graph, the aggregate demand of the economy has shifted from AD to AD1. The price level has increased from P1 to P2. Here general price level of the economy has increased higher portion than the increase of the real GDP. Because at Y1 output level economy has mostly reached to the full employment output level. Economy has used all the available resources at the full employment output level. So, increasing aggregate demand increase the general price level higher than the real output level.

2. Leftward shift of the aggregate supply curve

An another way of occurring the inflationary gap is the decrease of the short run aggregate supply. According to the following graph, the short-run aggregate supply curve of an economy has shifted to the left (from SRAS to SRAS1) as a result of the material price increase, nominal wage increase, and so on. So, the general price level has increased from P1 to P2 and the output level of the economy has decreased from Y1 to Y2. So, the economy is in a stagflation situation. Because both inflation and unemployment are increased by the negative shocks of the aggregate supply.

Case study: COVID 19 Pandemic impact on economy of Malaysia

What happened to the AD-AS model in a recession?

In a recession, output level of an economy in other words Gross Domestic Product (GDP) is decreased while unemployment is increased. According to the AD-AS model, a recession occurs when aggregate demand (AD) or short-run aggregate supply (SRAS) shift to the left. The effect of this change is lower output in the short-run equilibrium outcome.

As results of the COVID 19 pandemic, aggregate demand curve and aggregate supply curve of the Malaysia have been shifted to leftward. .

We can more descriptively discuss reasons for aggregate demand curve and aggregate supply curve leftward as follows.

What shifts the AD curve to the left?

Decrease of the private consumption

*Malaysia – Private consumption*
*(Department of Statistics Malaysia, 2021).*

In the year 2020, private consumption in Malaysia accounted for 75.2 percent from the GDP of the country. But it has dropped from 4.3 percent when compared with the previous year. According to above graph, especially private consumption has contracted from 22.9 percent in the second quarter of year 2020 when compared with the first quarter and private consumption has been contracted from 3.47 percent in the fourth quarter of year 2020 when compared with the third quarter of the year.

Bank Negara Malaysia and government of the Malaysia expected that private consumption expenditure will be rebounded from 8 percent in the year 2021. But now it seems, they could not achieve that target in the year 2021. Because private consumption has been contracted from 10.76 percent in the second quarter of year 2021 when compared with the first quarter.

According to BNM, major reasons for decreasing of the private consumption are increase of the unemployment and strict movement restrictions.

Decrease of the gross investment

*Malaysia – Nominal Fixed Investment (gross fixed capital formation)*
*(Department of Statistics Malaysia, 2021).*

According to the above graph, quarter 1, quarter 2 and quarter 4 in the year 2020, gross investment has been decreased from 4.28 percent, 20.1 percent and 4.22 percent when compared with the previous quarters. Because 53% of firms reported reduced orders from clients, up from 46% in early October 2020 (Kuriakose et al., 2021).

Specially, as results of Northern states rely on travellers from Kuala Lumpur and Selangor to patronise their food trails, there was a huge closure rate in the food and beverage industry. In the Eastern states of Malaysia, manufacturing firms and wholesale and retail firms that operate in the non food and beverage industries have also recorded higher closure rate. So, there was a higher demand decrease in the investment component of the economy. This was not recovered until the year end of 2021. Because in the quarter 2, gross investment has been decreased from 2.47 percent and in the quarter 3, gross investment has been decreased from 9.49 percent.

Decrease of the net exports

*Malaysia – Net exports*
*(Department of Statistics Malaysia, 2021).*

In the year 2020, net exports of the Malaysia have significantly decreased by the COVID 19 pandemic. As mentioned in the above graph, in quarter one of 2021, net exports have decreased from 25.95 percent than the previous quarter and in quarter two of 2021, net exports have decreased from 36.52 percent than the previous quarter. Both imports and exports have decreased by as a result of the COVID 19 pandemic. But exports have seriously damaged than imports. So, net exports have decreased. Major reason for decrease in net exports is contraction of the service sector of Malaysia. Especially Malaysian service export sector has recorded RM170.2 billion in the year 2019 while Malaysian service export sector only has recorded RM 92.6 billion in the year 2020 (Department of Statistics Malaysia Official Portal, 2021).

Government intervention

Government of Malaysia has introduced seven economic stimulus packages (such as PRIHATIN, Pemerkasa Plus and so on) by increasing government expenditure to reduce the negative effect of above-mentioned components. Total value of these economic stimulus packages was US$91 billion. But these economic packages were not sufficient to totally remove the bad effect of COVID 19 pandemic. So, finally aggregate demand curve has been shifted to leftward.

What shifts the AS curve to the left?

Unavailability of the inputs

Government of Malaysia and other governments of the countries have implemented movement controls to reduce the spread of the COVID 19 pandemic. So, manufacturing firms of the Malaysia have faced shortage of inputs. As examples we can say IHS Markit Malaysia Manufacturing Purchasing Managers’ Index – a performance indicator of the manufacturing sector – dropped to 48.4 in March 2020 from 48.5 in February 2020 (Azmi & Associates, 2022). Because supply chain of the manufacturing firms has been disrupted. Specially producers of non-critical products have faced with many supply chain disruptions since they are not allowed to import the inputs for the production. So, many producers have to stop their production and as a result of it, aggregate supply curve of the Malaysia has shifted to leftward.

Inflation

Higher inflation shifts aggregate supply curve to leftward. In the year 2021, inflation rate of Malaysia has been increased continuously. Annual inflation rate of Malaysia for the year 2021 is 2.5 percent which is very higher than pre COVID annual inflation rates (Mung, 2022). Following graph will present monthly inflation increase of Malaysia in the year 2021.

As a result of the higher inflation rate, prices of the inputs have increased. This has decreased the aggregate supply level of the country.