Back To CourseEconomics 102: Macroeconomics
15 chapters | 111 lessons
Jon has taught Economics and Finance and has an MBA in Finance
The U.S. economy experienced an amazing economic expansion during the 1990's. Referred to by economists as the 'dot com boom,' it was the longest on record since the U.S. government started keeping track - 107 months. The Internet, personal computers and other technologies were making workers much more productive, and business was booming. Investors in the stock market believed that the economy had entered a new era of never-ending Goldilocks growth. As a result, on some days, stock prices for technology companies were increasing by 20%-50% in a matter of hours. Many thought the good times would never end.
In the short-run, consumers were buying lots of goods and services. With all that demand, businesses hired lots of workers, eventually leading to low unemployment. So here we have an economic expansion. In the short-run, the economy is operating above its potential. Economists would say it's operating 'above the full employment level.' With firms hiring extra workers, a shortage of workers developed in some industries, which led to higher wages. Since wages are one of the biggest costs of businesses, businesses started losing profits as wages rose. To preserve their profit, they began laying off some workers and raising prices for goods and services. It took a while, but in the long term, the economy slowed back down to its normal level, or what economists call 'potential output.'
Although many people thought the good times would continue, they finally ended. After this long expansion, the economy slid into recession for eight months beginning in March of 2001.
In the short-run, demand declined when business investment fell more than six percent and exports fell by ten percent. With businesses doing poorly, they laid off workers and unemployment increased. At this point, the economy settled into a new groove that was below its potential. It took a while, but eventually, prices and wages fell, firms hired more workers and in the long-run, the economy returned to what economists call 'the full employment level of output,' which means the economy was at its potential again.
Fluctuations in economic output like these are not uncommon, but they are unpredictable. By using models, economists can illustrate what happens throughout this process and pinpoint events in the economy during the short-run and the long-run. With a good model, they can also estimate where the economy is at any given time and predict where it may go next.
The Aggregate Supply-Aggregate Demand model is a macroeconomic model that explains these ups and downs in output and prices. It's based on the theory of John Maynard Keynes presented in his work The General Theory of Employment, Interest, and Money. The Aggregate supply-Aggregate Demand model (or AS/AD for short) is a combination of the Classical Model, which describes how the economy is at full employment in the long-run, and the Keynesian Model, which describes an economy that experiences expansions and recessions.
Let's take a play-by-play look at how the economy fluctuates using this model, first in a recession, then in an expansion.
Before we begin, let's get familiar with the supply and demand curves in this model.
There are three different curves in this model:
Remember that wherever the short-run aggregate supply curve intersects with the aggregate demand curve, this is where the economy is now, and economists call it equilibrium. Now that we've looked at the curves, let's see how Keynes' AS/AD Model explains recessions and expansions.
First, let's see what happens behind the scenes of a recession. In the town of Ceelo, Bob's lawn business has all the workers it needs. Margie's cake business has all the workers it needs. Everyone in Ceelo that needs a job has one, and this is happening all over the economy. Everything is in balance and harmony. How wonderful! How do economists illustrate this?
The economy starts out in equilibrium at its potential output, which economists refer to as the full employment level of output. Here's what this looks like in the AS/AD Model. First look at the long-run aggregate supply curve, which is a vertical line. This is what we've been saying is the economy's long-run potential (what economists refer to as the full employment level of output). Notice that all three curves are intersecting. The short-run balance of the economy is the same as its long-run potential. Another way to say this is: actual output = potential output.
Now, let's say that demand in the economy slows way down. This means less demand for lawn cutting and less demand for cakes. This brings the economy below its potential. In response to lower sales, Bob and Margie cut back production. Bob mows fewer lawns, and Margie produces less cakes. Since wages are 'sticky,' it's difficult to lower them, so business owners like Bob and Margie decide to lay off workers instead. Drake and Dan, some of Bob's workers, are among those who lose their jobs. When employers all across the economy respond the same way, the unemployment rate increases. The economy is now in recession, or what economists call 'a recessionary gap.' Keynesian economists believe that when demand is too low, economic output can fall below the full employment level. So what does this look like?
The aggregate demand curve shifts leftward. The economy finds a new equilibrium, and as you can see from the scales on the left side and bottom side of the chart, this is at a lower price level and at a lower level of output. Notice that the aggregate demand curve is intersecting the short-run aggregate supply curve to the left of the long-run aggregate supply curve. That means the economy's actual output is below its potential.
Eventually, a surplus of workers develops. In Ceelo, for example, all the workers who were laid off are looking for new jobs. Some of them are even competing for the same jobs. Drake and Dan are great with mowing lawns, so they're both interviewing at the Ceelo Prices Home Improvement Store. (It's a great place, I've been there.) The challenge is, when they get there, there's a line of candidates for the job that runs all the way out into the parking lot and goes for almost a mile. A lot of people need jobs right now. Well, what's going to happen? Wages finally get 'unstuck' and begin to fall as some workers accept jobs with lower pay.
As wages fall, business owners like Bob and Margie find that their costs have gone down, so they can lower prices to attract new sales. Bob finally lowers the price of his cut from $25 to $20, let's say, to attract new customers. Margie puts some of her cakes on sale to generate more sales. When sales in the economy increase, Bob, Margie and all the other employers hire more workers again. Now, everyone who needs work is working again! Everything in Ceelo and in the whole economy is in balance and harmony once more!
In the AS/AD model, this means aggregate supply increases, so the short-run aggregate supply curve shifts back to the right. The economy reaches a new long-run equilibrium, back at its full employment level (or potential) again. This brings economic output right back where it started at the full employment level of output, but prices are lower than before.
So, it's a 3-step process. At point one, the economy is at its potential. At point two, the economy is below potential in the short-run. Then, at point three, which represents the long-run, the economy has returned to its potential again, but notice that it's at a lower price level than where it started at point one.
So far, we've talked about a recession. Now let's look at the opposite situation, when the economy is in an expansion. In the town of Ceelo, everything is in balance and harmony, meaning that everyone is fully employed. Workers across the entire economy are also fully employed.
Now, let's say that consumers become more optimistic about the future, and they decide to spend more of their incomes. So, consumption increases. That means that demand for Bob's lawn services has gone up. Demand for Margie's cakes has also gone up. Demand for goods and services across the economy has gone up. What does this look like in the AS/AD model?
The aggregate demand curve shifts to the right, and this extra demand begins to pull prices up as businesses like Bob's and Margie's start expanding. Bob and Margie will hire additional workers in the short-run to keep up with higher demand, and unemployment goes down. The economy is now in an expansion, operating above its potential. This is what happens in the short-run, and economists call this 'an expansionary gap.'
Eventually, a shortage of workers develops when Bob, Margie and all the other employers have hired everyone who's available to work. They even have Bob's son, Bobby Jr., helping out and also the Easter Bunny (let's face it; this bunny is unemployed most of the time). To help mow the lawns, they've even placed dozens of guinea pigs on some lawns to eat grass. This labor shortage (particularly among the guinea pigs, let me say that) puts upward pressure on wages as workers become more scarce and start demanding higher pay (hey, I don't know about you, but there's no way I could say no to the Easter Bunny's request for a raise either).
As you can see here, in the AS/AD model, just like it was in a recession, there is a 3-step process. The economy starts in an equilibrium equal to the long-run potential, then it settles in a new short-run equilibrium below its long-run potential and eventually settles again by returning to the long-run potential.
Alright, time out for a minute. Here's a quick observation that is important. As you can see, the short-run aggregate supply curve is upward sloping, while the long-run aggregate supply curve is vertical. You need to know why. The SRAS is upward sloping because nominal wages and prices do not quickly respond to changes in the price level. Another way to say this is: wages and prices are 'sticky' because they adjust slowly to the short-term ups and downs in the economy.
On the other hand, the long-run aggregate supply curve is vertical. The LRAS curve is vertical because in the long-run, wages and prices are flexible. Looking at both of these curves together, we can say that the aggregate supply curve is vertical in the long-run but not in the short-run. This is the Aggregate Supply-Aggregate Demand Model. It has a lot of moving parts, including three curves, but the concepts are fairly straightforward.
It explains what happens in the economy in the short-run and the long-run. It incorporates the classical economic idea that the economy is at its potential in the long-run, but also Keynes' observation during the great depression that the economy can be above or below potential, sometimes for a long time.
To summarize the key points from this lesson, the Aggregate Supply-Aggregate Demand Model is a macroeconomic model that explains the ups and downs in output and prices. It's based on the theory of John Maynard Keynes that was developed from his observations during the Great Depression.
The Aggregate Supply-Aggregate Demand model (or AS/AD for short) is a combination of the Classical Model, which describes how the economy is at full employment in the long-run, and the Keynesian Model, which describes how the economy falls into recession (or experiences expansion) in the short-run.
Keynes observed that wages and prices are 'sticky' because they adjust slowly to the short-term ups and downs in the economy. The long-run aggregate supply curve is vertical because in the long-run, wages and prices are flexible. The aggregate supply curve is vertical in the long-run but not in the short-run.
According to the AS/AD Model, the economy starts out at its long-run potential, which economists call the full employment level of output. During a recession, actual output falls below potential output. In the short-run, real GDP falls, and the general level of prices falls. In the long-run, there is no change in real GDP, and the general level of prices falls.
Now, from the opposite perspective. During an expansion, actual economic output rises above potential output. In the short-run, real GDP rises, and the general level of prices rises. In the long-run, there is no change in real GDP, and the general level of prices rises.
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Back To CourseEconomics 102: Macroeconomics
15 chapters | 111 lessons