Economic Principles Ch19. Aggregate demand-aggregate supply (AD-AS) model and price determination

Chapter 19. The Aggregate Demand-Aggregate Supply (AD-AS) Model and Price Determination

While the IS-LM model is a short-term analysis with a fixed price level, the AD-AS model is a more comprehensive tool for analyzing the macroeconomy, incorporating fluctuations in the price level ($P$). This chapter analyzes how aggregate demand and aggregate supply are determined, and how the overall economic equilibrium shifts.

---

1. Aggregate Demand (AD)

This represents the negative (-) relationship between the price level and national income.

(1) Causes of the Downward Slope

1. Interest Rate Effect (Keynes Effect): Fall in price level $\rightarrow$ Increase in real money supply $\rightarrow$ Fall in interest rate $\rightarrow$ Increase in investment ($I$) $\rightarrow$ Increase in income ($Y$).
2. Real Balance Effect (Pigou Effect): Fall in price level $\rightarrow$ Increase in real value of money held by households $\rightarrow$ Increase in consumption ($C$) $\rightarrow$ Increase in income ($Y$).
3. Net Export Effect: Fall in price level $\rightarrow$ Fall in relative price of domestic goods $\rightarrow$ Increase in exports $\rightarrow$ Increase in income ($Y$).

---

2. Aggregate Supply (AS)

This is the total output that firms are willing to produce according to the price level.

(1) Short-Run Aggregate Supply Curve (SRAS)

• Upward-sloping: Due to wage or price stickiness, when prices rise, firms’ real profits increase, leading them to expand production.
• Views by School of Thought: The Keynesian school views output as changing in the short run due to workers’ “money illusion” or “information asymmetry.”

(2) Long-Run Aggregate Supply Curve (LRAS)

• Vertical line: In the long run, all prices and wages adjust flexibly, so it becomes a vertical line at the Potential GDP (Full Employment GDP) level, regardless of the price level.

---

3. Economic Equilibrium and Fluctuations (Shock Analysis)

(1) Aggregate Demand Shocks

• Shift of $AD$ to the right $\rightarrow$ Rise in price level ($P \uparrow$), increase in income ($Y \uparrow$). (Economic overheating)

(2) Aggregate Supply Shocks: Stagflation

• Negative shock: Occurs when $AS$ shifts to the left due to a surge in oil prices, etc.
• Outcome: The worst-case scenario where a rise in prices ($P \uparrow$) and a fall in income ($Y \downarrow$, rise in unemployment) occur simultaneously.

---

4. Policy Lags

It takes time for government policies to take effect.

• Inside lag: The time from recognizing a situation to deciding on a policy (fiscal policy tends to be long).
• Outside lag: The time from policy implementation to the real economy’s reaction (monetary policy tends to be long).

---

5. Conclusion: Prices Are the Economic Thermometer

The AD-AS model provides a framework to logically explain the high inflation and economic recessions we encounter in the news. In the long run, the economy always tries to recover to its potential level, and reducing the pain during that process is the raison d’être of macroeconomic policy.

---

📖 References

• [Macroeconomics] - Byung-ryul Jung: In-depth derivation of the AD-AS model.
• [Prices and Monetary Policy] - Bank of Korea: Real-world policy cases.

---

Great job. In the next session, we will study the Rational Expectations Hypothesis and the New Classical School, analyzing how people’s “expectations” can neutralize policy effects.