# Aggregate Demand and Supply 3

**Topics:**Inflation, Aggregate demand, Supply and demand

**Pages:**16 (6108 words)

**Published:**September 23, 2008

The first formal macroeconomics model introduced by the text is called the Aggregate Supply Aggregate Demand Model, which will hereafter be referred to as the AS/AD model. The AS/AD model is useful for evaluating factors and conditions which effect the level of Real Gross Domestic Product(GDP adjusted for inflation) and the level of inflation. Like the microeconomic model, the AS/AD model is a comparative statics model. The model's insights, therefore, are obtained by identifying and initial equilibrium condition, then "shocking" the model by charging one or more of the parameters, then evaluating the resulting new equilibrium. In recent years, many macroeconomic textbooks at the principles and intermediate levels have adopted the aggregate-supply/aggregate-demand (AS-AD) framework [Baumol and Blinder, 1988, Ch. 11; Gordon, 1987, Ch. 6; Lipsey, Steiner, and Purvis, 1984, Ch. 30; Mankiw, 1992, Ch. 11]. The objective was to allow for supply shocks in a Keynesian framework and to generate more satisfactory predictions about the behavior of the price level. In one version of the aggregate-supply curve, the components of the AS-AD model as usually used are contradictory.(1) An interpretation of the model to eliminate the logical inconsistencies makes it a special case of rational-expectations macro models. In this mode, the model has no Keynesian characteristics and delivers the policy prescriptions that are familiar from the rational-expectations literature. An alternative version of the aggregate-supply curve leads to what used to be called the complete Keynesian model: the goods market clears but the labor market has chronic excess supply. This model was rejected long ago for good reasons and should not be resurrected now.

Introduction to the Aggregate Supply/Aggregate

Demand Model

This model is a mere aggregation of the microeconomic model. Instead of the quantity of output of a single industry, this model represents the quantity of output of an entire economy (or, in other words, national production).Refer to Figure 2.1 for an example of the AS/AD model. As can be seen, two variables are represented by the model. The quantity variable on the horizontal axis is now represented by real gross domestic product (Y). This is the measure of the true value of annual national production, and is adjusted for inflation. The level of price inflation is represented on the upright axis. A suitable economic statistic for this value would be the rate of inflation as determined by the Implicit Price Deflator, the value used to compute real GNP from nominal, inflated GNP.1The equilibrium level of real national output (real GDP) is determined by the interaction of the AS and AD curves. This equilibrium also determines the national inflation rate. The Aggregate Demand (AD) curve has its traditional negative slope. This implies that, given any amount of nominal income, purchasers will be able to buy more real goods at lower prices than they would at higher prices....

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