Discuss the importance ASAD model in explaining the macroeco

Discuss the importance AS-AD model in explaining the macroeconomic conditions of the economy and business cycles like recessions.

What factors shift AS and AD curves? How do you explain macroeconomic fluctuations using AS-AD model and AS/AD curves?

Solution

The business cycle consists of a peak, recession, trough, and expansions. • A standard definition of a recession is a decrease in real GDP that lasts for at least two quarters (six months). The NBER (National Bureau of Economic Research) uses a broader definition of recession to date businesscycle turning points. It defines a recession as “a period of significant decline in total output, income, employment, and trade, usually last ing from six months to a year, and marked by widespread contractions in many sectors of the economy.”

Real GDP depends on labor, capital, technology, land, and entrepreneurial talent. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP. When the quantity of labor demanded equals the quantity of labor supplied, there is full employment in the labor market and real GDP equals potential GDP. Aggregate demand is the quantity of real GDP demanded is the sum of consumption expenditure (C ), investment (I ), government expenditures (G ), and net exports (X M ), or Y = C + I + G + (X M ).

The AS curve is upward sloping. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby in creasing the quantity of labor employed and hence increasing real GDP.

When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the AS curve. The AS curve, however, does not shift. • When potential GDP increases, aggregate supply increases and AS curve shifts right ward. The potential GDP line also shifts rightward. • Shortrun aggregate supply changes and the AS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other re source prices decreases shortrun aggregate supply and shifts the AS curve leftward. In this case, the potential GDP line does not shift.

The AD curve is downward sloping. Moving along the aggregate demand curve the only thing that changes is the price level. Any factor that influences expenditure plans other than the price level changes aggregate demand and shifts the aggregate demand curve.

Fluctuations in aggregate demand are one of the sources of the business cycle. Ignoring changes in potential GDP, when aggregate demand increases, the equilibrium moves rightward along the AS curve so that real GDP increases and the economy is in an expan sion. When aggregate demand decreases, the equilibrium moves leftward along the AS curve so that real GDP decreases and the economy is in a recession.

Fluctuations in Aggregate Supply

• Some business cycle fluctuations are driven by shifts in shortrun aggregate supply. An increase in energy prices decreases the shortrun aggregate supply and shifts the SAS curve leftward. The price level increases and real GDP decreases. The combination of re cession and higher inflation is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks.