Aggregate Demand and Supply
Classical AD/AS Model
The classical AD/AS model is an expansion on the regular demand and supply model we all know and love.
What's are the Elements of a Classical AD/AS Model?
Price Level (inflation) is on the y axis
Real GDP (or economic activity) is shown on the x axis
Includes an aggregate demand line represented by AD
Includes Short Run Aggregate Supply Line - that is the current level of aggregate supply being achieved by the economy
Includes the Long Run Aggregate Supply Line - that is the highest level of aggregate supply that can be achieved with full employment of resources
A contractionary gap (shown above) is where the actual level of real GDP (Y1) is below the potential output at full employment (Yfe). This occurs where the equilibrium intersection between SRAS and AD is on the left hand side of the LRAS line.
What is the Effect of a Contractionary Gap?
At a contractionary gap, increases in aggregate demand will cause little or no changes in price level. This is because, there is still spare capacity within the economy with employment of additional resources not exceeding the maximum capacity of the economy.
Expansionary Gap (Also Called Inflationary Gap)
An expansionary gap (shown above) is where the actual level of real GDP (Y1) is above the potential output at full employment (Yfe). This occurs where the equilibrium intersection between SRAS and AD is on the right hand side of the LRAS line.
What is the Effect of a Expansionary Gap?
At a contractionary gap, increases in aggregate demand will cause increases in price level and no change to real GDP. This is because the level of output is already at full employment of resources, so output cannot increase any further. Increasing aggregate demand will increase competition for resources, driving up prices for resources. For example, during the mining boom, there was a labour shortage for the mining industry, so the mining industry offered high wages to attract already employed labour. As the labour was simply changing industries, real GDP changed slightly, while price levels rose from wage growth.
Why is LRAS a Straight Line?
Long Run Aggregate Supply (LRAS) is represented as a straight line because at this point, the economy is at full employment of resources. Increasing aggregate demand will not increase output as all resources are already employed. This will only result in inflation as there will be increased competition for resources, requiring firms to offer higher prices to accumulate scarce resources, such as labour.
This is shown in the above model. The straight line of LRAS shows that increasing Aggregate Demand from AD1 to AD2 will only result in an increase in price level from P1 to P2 and no increase in Real GDP which remains stationary at Yfe.