Skip to ContentGo to accessibility pageKeyboard shortcuts menu
OpenStax Logo
Principles of Macroeconomics for AP® Courses

10.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation

Principles of Macroeconomics for AP® Courses10.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
Menu
Table of contents
  1. Preface
  2. 1 Welcome to Economics!
    1. Introduction
    2. 1.1 What Is Economics, and Why Is It Important?
    3. 1.2 Microeconomics and Macroeconomics
    4. 1.3 How Economists Use Theories and Models to Understand Economic Issues
    5. 1.4 How Economies Can Be Organized: An Overview of Economic Systems
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  3. 2 Choice in a World of Scarcity
    1. Introduction to Choice in a World of Scarcity
    2. 2.1 How Individuals Make Choices Based on Their Budget Constraint
    3. 2.2 The Production Possibilities Frontier and Social Choices
    4. 2.3 Confronting Objections to the Economic Approach
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  4. 3 Demand and Supply
    1. Introduction to Demand and Supply
    2. 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
    3. 3.2 Shifts in Demand and Supply for Goods and Services
    4. 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
    5. 3.4 Price Ceilings and Price Floors
    6. 3.5 Demand, Supply and Efficiency
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  5. 4 Labor and Financial Markets
    1. Introduction to Labor and Financial Markets
    2. 4.1 Demand and Supply at Work in Labor Markets
    3. 4.2 Demand and Supply in Financial Markets
    4. 4.3 The Market System as an Efficient Mechanism for Information
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  6. 5 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 5.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 5.2 Adjusting Nominal Values to Real Values
    4. 5.3 Tracking Real GDP over Time
    5. 5.4 Comparing GDP among Countries
    6. 5.5 How Well GDP Measures the Well-Being of Society
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  7. 6 Economic Growth
    1. Introduction to Economic Growth
    2. 6.1 The Relatively Recent Arrival of Economic Growth
    3. 6.2 Labor Productivity and Economic Growth
    4. 6.3 Components of Economic Growth
    5. 6.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  8. 7 Unemployment
    1. Introduction to Unemployment
    2. 7.1 How the Unemployment Rate Is Defined and Computed
    3. 7.2 Patterns of Unemployment
    4. 7.3 What Causes Changes in Unemployment over the Short Run
    5. 7.4 What Causes Changes in Unemployment over the Long Run
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  9. 8 Inflation
    1. Introduction to Inflation
    2. 8.1 Tracking Inflation
    3. 8.2 How Changes in the Cost of Living Are Measured
    4. 8.3 How the U.S. and Other Countries Experience Inflation
    5. 8.4 The Confusion Over Inflation
    6. 8.5 Indexing and Its Limitations
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  10. 9 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 9.1 Measuring Trade Balances
    3. 9.2 Trade Balances in Historical and International Context
    4. 9.3 Trade Balances and Flows of Financial Capital
    5. 9.4 The National Saving and Investment Identity
    6. 9.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 9.6 The Difference between Level of Trade and the Trade Balance
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  11. 10 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Demand/Aggregate Supply Model
    2. 10.1 Macroeconomic Perspectives on Demand and Supply
    3. 10.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 10.3 Shifts in Aggregate Supply
    5. 10.4 Shifts in Aggregate Demand
    6. 10.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 10.6 Keynes’ Law and Say’s Law in the AD/AS Model
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  12. 11 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 11.1 Aggregate Demand in Keynesian Analysis
    3. 11.2 The Building Blocks of Keynesian Analysis
    4. 11.3 The Expenditure-Output (or Keynesian Cross) Model
    5. 11.4 The Phillips Curve
    6. 11.5 The Keynesian Perspective on Market Forces
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
  13. 12 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 12.1 The Building Blocks of Neoclassical Analysis
    3. 12.2 The Policy Implications of the Neoclassical Perspective
    4. 12.3 Balancing Keynesian and Neoclassical Models
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  14. 13 Money and Banking
    1. Introduction to Money and Banking
    2. 13.1 Defining Money by Its Functions
    3. 13.2 Measuring Money: Currency, M1, and M2
    4. 13.3 The Role of Banks
    5. 13.4 How Banks Create Money
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  15. 14 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 14.1 The Federal Reserve Banking System and Central Banks
    3. 14.2 Bank Regulation
    4. 14.3 How a Central Bank Executes Monetary Policy
    5. 14.4 Monetary Policy and Economic Outcomes
    6. 14.5 Pitfalls for Monetary Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  16. 15 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 15.1 How the Foreign Exchange Market Works
    3. 15.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 15.3 Macroeconomic Effects of Exchange Rates
    5. 15.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  17. 16 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 16.1 Government Spending
    3. 16.2 Taxation
    4. 16.3 Federal Deficits and the National Debt
    5. 16.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 16.5 Automatic Stabilizers
    7. 16.6 Practical Problems with Discretionary Fiscal Policy
    8. 16.7 The Question of a Balanced Budget
    9. Key Terms
    10. Key Concepts and Summary
    11. Self-Check Questions
    12. Review Questions
    13. Critical Thinking Questions
    14. Problems
  18. 17 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 17.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 17.2 Fiscal Policy, Investment, and Economic Growth
    4. 17.3 How Government Borrowing Affects Private Saving
    5. 17.4 Fiscal Policy and the Trade Balance
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  19. 18 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 18.1 The Diversity of Countries and Economies across the World
    3. 18.2 Improving Countries’ Standards of Living
    4. 18.3 Causes of Unemployment around the World
    5. 18.4 Causes of Inflation in Various Countries and Regions
    6. 18.5 Balance of Trade Concerns
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  20. A | The Use of Mathematics in Principles of Economics
  21. B | Indifference Curves
  22. C | Present Discounted Value
  23. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
    17. Chapter 17
    18. Chapter 18
  24. References
  25. Index

Learning Objectives

By the end of this section, you will be able to:
  • Identify periods of economic growth and recession using the aggregate demand/aggregate supply model
  • Explain how unemployment and inflation impact the aggregate demand/aggregate supply model
  • Evaluate the importance of the aggregate demand/aggregate supply model

The AD/AS model can convey a number of interlocking relationships between the four macroeconomic goals of growth, unemployment, inflation, and a sustainable balance of trade. Moreover, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach that focuses on aggregate demand and the short run, while also including the Say’s law approach that focuses on aggregate supply and the long run. These advantages are considerable. Every model is a simplified version of the deeper reality and, in the context of the AD/AS model, the three macroeconomic goals arise in ways that are sometimes indirect or incomplete. In this module, we consider how the AD/AS model illustrates the three macroeconomic goals of economic growth, low unemployment, and low inflation.

Growth and Recession in the AD/AS Diagram

In the AD/AS diagram, long-run economic growth due to productivity increases over time will be represented by a gradual shift to the right of aggregate supply. The vertical line representing potential GDP (or the “full employment level of GDP”) will gradually shift to the right over time as well. A pattern of economic growth over three years, with the AS curve shifting slightly out to the right each year, was shown earlier in Figure 10.7 (a). However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in the AD/AS diagram.

In the short run, GDP falls and rises in every economy, as the economy dips into recession or expands out of recession. Recessions are illustrated in the AD/AS diagram when the equilibrium level of real GDP is substantially below potential GDP, as occurred at the equilibrium point E0 in Figure 10.9. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP, as shown at equilibrium point E1 in that earlier figure.

Unemployment in the AD/AS Diagram

Two types of unemployment were described in the Unemployment chapter. Cyclical unemployment bounces up and down according to the short-run movements of GDP. Over the long run, in the United States, the unemployment rate typically hovers around 5% (give or take one percentage point or so), when the economy is healthy. In many of the national economies across Europe, the rate of unemployment in recent decades has only dropped to about 10% or a bit lower, even in good economic years. This baseline level of unemployment that occurs year-in and year-out is called the natural rate of unemployment and is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.

Link It Up

Visit this website for data on consumer confidence.

QR Code representing a URL

In the AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full employment level of GDP. Returning to Figure 10.9, relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as in the equilibrium point E1. Conversely, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point E0. The factors that determine the natural rate of unemployment are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP or full employment GDP in a given economy.

Inflationary Pressures in the AD/AS Diagram

Inflation fluctuates in the short run. Higher inflation rates have typically occurred either during or just after economic booms: for example, the biggest spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation generally decline during recessions. As an extreme example, inflation actually became negative—a situation called “deflation”—during the Great Depression. Even during the relatively short recession of 1991–1992, the rate of inflation declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short recession of 2001, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007–2009, the rate of inflation declined from 3.8% in 2008 to –0.4% in 2009. Some countries have experienced bouts of high inflation that lasted for years. In the U.S. economy since the mid–1980s, inflation does not seem to have had any long-term trend to be substantially higher or lower; instead, it has stayed in the range of 1–5% annually.

Link It Up

Visit this website for data on business confidence.

QR Codes representing a URL

The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the AS curve. In Figure 10.10 (a), there is a shift of aggregate demand to the right; the new equilibrium E1 is clearly at a higher price level than the original equilibrium E0. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods, because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.

The two graphs show how a shift in aggregate demand or supply can cause inflationary pressure. The graph on the left shows two aggregate demand curves to represent a shift to the right. The graph on the right shows two aggregate supply curves to represent a shift to the left.
Figure 10.10 Sources of Inflationary Pressure in the AD/AS Model (a) A shift in aggregate demand, from AD0 to AD1, when it happens in the area of the SRAS curve that is near potential GDP, will lead to a higher price level and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1) than the original equilibrium. (b) A shift in aggregate supply, from SRAS0 to SRAS1, will lead to a lower real GDP and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1), while the original equilibrium (E0) is at the lower price level (P0).

An alternative source of inflationary pressures can occur due to a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—and causes the aggregate supply curve to shift back to the left. In Figure 10.10 (b), the shift of the SRAS curve to the left also increases the price level from P0 at the original equilibrium (E0) to a higher price level of P1 at the new equilibrium (E1). In effect, the rise in input prices ends up, after the final output is produced and sold, being passed along in the form of a higher price level for outputs.

The AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years. There are two explanations for why inflation may persist over time. One way that continual inflationary price increases can occur is if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the steep portion of the SRAS curve. A second possibility is that, if inflation has been occurring for several years, a certain level of inflation may come to be expected. For example, if consumers, workers, and businesses all expect prices and wages to rise by a certain amount, then these expected rises in the price level can become built into the annual increases of prices, wages, and interest rates of the economy. These two reasons are interrelated, because if a government fosters a macroeconomic environment with inflationary pressures, then people will grow to expect inflation. However, the AD/AS diagram does not show these patterns of ongoing or expected inflation in a direct way.

Importance of the Aggregate Demand/Aggregate Supply Model

Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts. For example, start with the three macroeconomic goals of growth, low inflation, and low unemployment. Aggregate demand has four elements: consumption, investment, government spending, and exports less imports. Aggregate supply reveals how businesses throughout the economy will react to a higher price level for outputs. Finally, a wide array of economic events and policy decisions can affect aggregate demand and aggregate supply, including government tax and spending decisions; consumer and business confidence; changes in prices of key inputs like oil; and technology that brings higher levels of productivity.

The aggregate demand/aggregate supply model is one of the fundamental diagrams in this course (like the budget constraint diagram introduced in the Choice in a World of Scarcity chapter and the supply and demand diagram introduced in the Demand and Supply chapter) because it provides an overall framework for bringing these factors together in one diagram. Indeed, some version of the AD/AS model will appear in every chapter in the rest of this book.

PreviousNext
Citation/Attribution

Want to cite, share, or modify this book? This book uses the Creative Commons Attribution License and you must attribute OpenStax.

Attribution information
  • If you are redistributing all or part of this book in a print format, then you must include on every physical page the following attribution:
    Access for free at https://openstax.org/books/principles-macroeconomics-ap-courses/pages/1-introduction
  • If you are redistributing all or part of this book in a digital format, then you must include on every digital page view the following attribution:
    Access for free at https://openstax.org/books/principles-macroeconomics-ap-courses/pages/1-introduction
Citation information

© Jan 31, 2022 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.