Macroeconomic Theory and the AD-AS Model

The position of the AD curve can shift due to non-price determinants of its components: Consumption ($C$), Investment ($I$), Government spending ($G$), and Net Exports ($X - Z$).

Aggregate Supply (AS)

The Aggregate Supply curve describes how much the economy can produce at different price levels. We distinguish between two time horizons:

1. Short-Run Aggregate Supply (SRAS): The SRAS curve is upward sloping. This is because, in the short run, changes in the price level affect real wages. If prices rise while wages remain relatively fixed, firms find it more profitable to increase employment and production.
2. Long-Run Aggregate Supply (LRAS): The LRAS curve is vertical. This indicates that in the long run, the economy's level of output ($Y$) is determined by its productive capacity and is independent of the price level ($P$).

Exam Tip: Remember that the slope of the AS curve is crucial when analyzing policy. The AS curve determines how a change in demand is "split" between a change in total production ($\Delta Y$) and a change in the price level ($\Delta P$).

Demand Management and Supply Shocks

Economists use the AD-AS model to predict how shifts in demand or supply will impact the economy.

Demand Management

When the government or central bank attempts to influence the economy by shifting the AD curve, they are engaging in demand management.

• Increase in AD: If AD shifts to the right (e.g., through expansionary policy), both total production ($Y$) and the price level ($P$) increase.
• Decrease in AD: If AD shifts to the left (e.g., through contractionary policy), both $Y$ and $P$ decrease.

Supply Shocks and Stagflation

Unlike demand shifts, changes in the AS curve can lead to more difficult economic scenarios.

• Adverse Supply Shocks: An adverse shock, such as a sudden increase in the price of imported oil, shifts the SRAS curve to the left. This causes a simultaneous decrease in production ($Y$) and an increase in the price level ($P$).
• Stagflation: This specific combination of stagnant growth (low $Y$) and high inflation (high $P$) is known as stagflation.
• Positive Supply Shocks: Conversely, an increase in productivity (e.g., technological advancement) shifts the AS curve to the right, which increases $Y$ and decreases $P$.

Monetary and Fiscal Policy

To manage the economy, authorities use two main types of policy: Monetary Policy (managed by the central bank) and Fiscal Policy (managed by the government).

The Monetary Transmission Mechanism

The monetary transmission mechanism explains how changes in the monetary sector (like interest rates) affect the real economy. In the AD-AS framework, the process generally follows this chain: $\Delta i \Rightarrow \Delta I \Rightarrow \Delta A \Rightarrow \Delta Y \text{ and } \Delta P$ Where:

• $\Delta i$ is a change in the interest rate.
• $\Delta I$ is a change in investment spending.
• $\Delta A$ is a change in aggregate spending.
• $\Delta Y$ and $\Delta P$ are the resulting changes in income and price level.

While the interest rate channel is primary, other channels include the exchange rate, asset prices, and credit channels.

Policy Tools and Lags

Policymakers must contend with various lags that delay the effectiveness of these tools:

1. Recognition Lag: The time taken to realize a problem exists.
2. Decision Lag: The time taken to choose a policy (longer for fiscal policy due to political processes).
3. Implementation Lag: The time taken to put the policy into effect.
4. Impact Lag: The time it takes for the policy to actually affect $Y$ and $P$ (typically longer for monetary policy).