Office Hours: Using the AD-AS Model

We’re going to explore the mechanics of the aggregate-demand aggregate-supply (AD-AS) model. In our example, we’ll measure the economy’s inflation rate as well as the real GDP growth rate on the vertical and horizontal axes.

A country’s normal GDP growth rate is represented by the vertical line known as the long-run aggregate supply (LRAS) curve. Why is it vertical? Well, an economy’s long-run growth rate depends on the fundamental factors of production rather than nominal factors, like inflation. If there are no changes to the fundamental factors, the economy will tend to return to this level of economic growth over a long enough timeline. Think of the LRAS curve as the “North Star” of economic growth.

Now the aggregate demand (AD) curve is affected by inflation. We use the quantity theory of money to derive it. The AD curve shows any combination of the inflation rate plus the real GDP growth rate that add up to a constant amount (this is also the growth rate of nominal GDP).

Finally, we also have the short-run aggregate supply (SRAS) curve. Even if the economy tends to return to the LRAS level over time, real economic growth can slow down for a little while – such as during a recession. The SRAS helps us show these scenarios.

In the video, we’ll dive into the factors that cause these curves to shift on the graph and what this model can tell us about the economy.