Unit 3- The AS/AD Model

The AS/AD Model 
The equilibrium of AS and AD determines current output (GDPᵣ) 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

Inflationary Gap
Exists when equilibrium occurs beyond full employment output.

Three Ranges of SRAS

1. Keynesian/horizontal range 

• Occurs when we are in a recession or depression, not fully using all of our resources, and    below full employment.

2. Intermediate-range 

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

3. Classical or vertical range 

• Occurs 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

• An increase in the average price level resulting from an increase in total spending in the economy
• C, Ig, G, and Xn make the AD in a nation.
• AD is always increasing.

Cost-push inflation

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
• Higher prices for important components/raw materials 
• A depreciation in the exchange rate causing a rise in import costs
• An increase in business taxes(e.g. a value-added tax (VAT) or environmental taxes) such as a carbon tax
• Expectations in inflation rate

Some factors affecting inflationary pressures:

• 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
• Rapid expansion of money and credit from banks → Rising consumer spending financed by loans → Demand-pull inflation risk