Unit III: The AS/AD Model

The AS/AD model shows that the equilibrium of AS and AD determines the current output (real GDP) and the price level.

Full employment: equilibrium exists where AD intersects SRAS and LRAS at the same point



Recessionary gap: exists when equilibrium occurs below full-employment output


An inflationary gap exists when equilibrium occurs beyond full employment output.

Three ranges of SRAS: Keynesian or horizontal range, intermediate range, and classical or vertical range.

Keynesian or horizontal range:

• recession or depression
•  not fully using all of our resources
•  below full employment.

Intermediate-range:

• resources are getting closer to full employment levels, which creates upward pressure on wages and prices.

Classical or vertical range 

• when real GDP is at a level below the full employment level where any increase in demand will result only in an increase in prices.

Demand-pull inflation is an increase in the average price level resulting from an increase in total spending in the economy. C, I, G, and X make the AD in a nation. AD always increases.

Cost-push inflation is when firms respond to rising costs by increasing their prices to protect profit margins. It can be caused by the following:

• Rising unit labor costs
• An increase in the price of raw materials
• A depreciation in the exchange rate causing a rise in import costs
• An increase in business taxes, for example, a value-added tax (VAT) or environmental taxes such as a carbon tax
• Expectations in the inflation rate

Some factors affecting inflationary pressures are as follows:

• Rising property prices -> increased consumer wealth -> demand-pull inflation risk
• Increasing world oil prices -> higher costs for businesses -> cost-push inflation risk
• Depreciating exchange rate -> increased import prices and rising exports -> cost-push and demand-pull inflation risk
• The rapid expansion of money and credit from banks -> rising consumer spending financed  by loans -> demand-pull inflation risk