MAcro CHAPTER 3.6:

CHAPTER SUMMARY

Just like with supply & demand, the AD-AS model changes all the time. Aggregate Demand (AD) can shift any time any part of the C + I + G + Nx formula changes, and Aggregate Supply (AS) can shift any time resource prices, government action, or productivity changes.

The two charts below show how a change in demand looks on the AD-AS model. As you can see, a decrease in demand leads to a decrease in both price level and real GDP, and a recessionary gap. An increase in demand leads to an increase in both price level and real GDP, and an inflationary gap. We call this scenario demand-pull inflation because the rise in price level is being caused by aggregate demand.

The next two charts below show how a change in SRAS looks on the AD-AS model. As you can see, a decrease in supply leads to an increase in price level, a decrease in Real GDP, and a recessionary gap. When SRAS decreases because of an increase in production costs, we call this scenario cost-push inflation because the rise in price level is being caused by a rise in costs. An increase in supply, meanwhile leads to a decrease in price level, an increase in Real GDP, and an inflationary gap.

Changes to AS can be very severe when there is a supply shock - an unexpected, sudden change in the availability of resources needed for production. A negative supply shock is when resources suddenly become unavailable, such as due to a war breaking out in a country that supplies a certain resource. A positive supply shock is when resources suddenly become available, such as the discovery of a huge mine of a particular metal used in production.

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