A-Level Economics Notes on the AD/AS Curve

Definitions

1. Aggregate Supply (AS): The total quantity of goods and services that producers are willing and able to supply at different price levels in an economy.
2. Aggregate Demand (AD): The total quantity of goods and services demanded across all levels of an economy at a particular price level and in a given period.
3. Price Level: A measure of the average prices of goods and services in the economy.
4. Real GDP: The value of all finished goods and services produced within a country’s borders in a specific time period, adjusted for inflation.
5. Short-Run Aggregate Supply (SRAS): The total production of goods and services in the short term, influenced by price levels and production costs.
6. Long-Run Aggregate Supply (LRAS): The total production of goods and services when wages and resource prices have fully adjusted to changes in the economy.
7. Equilibrium: The point where the AS and AD curves intersect, representing the economy’s optimal price level and output level.
8. Recessionary Gap: The amount by which the economy’s actual production is less than its potential production.
9. Inflationary Gap: The amount by which the economy’s actual production exceeds its potential production.
10. Fiscal Policy: Government actions involving spending and taxation to influence the economy.
11. Monetary Policy: Central bank actions involving the manipulation of interest rates and money supply to influence the economy.
12. Consumer Confidence: A measure of how optimistic consumers are about the economy’s future; affects consumer spending.
13. Interest Rate: The cost of borrowing money, set by a country’s central bank.
14. Exchange Rate: The value of one currency in terms of another.
15. Stagflation: A situation where the economy experiences stagnant growth, high unemployment, and high inflation simultaneously.

Diagrams

Figure 1: AS/AD Curve

AS Curve

AS (Aggregate Supply): The AS curve shows the total quantity of goods and services that producers are willing and able to supply at different price levels in an economy.

Factors Affecting the AS Curve

1. Input Costs: Lower costs for raw materials or labor can shift the AS curve to the right, indicating more goods can be produced at the same price level.
2. Technological Advancements: Improvements in technology can also shift the AS curve to the right, as production becomes more efficient.
3. Government Policies: Tax cuts or subsidies can reduce production costs, shifting the AS curve to the right.
4. Labor Force: An increase in skilled labor can make production more efficient, shifting the AS curve to the right.

Rightward Shifts in AS Curve

1. Example: Technological Boom: The advent of the internet significantly reduced costs and increased efficiency, shifting the AS curve to the right.
2. Example: Tax Cuts: In 2017, the U.S. implemented tax cuts that reduced corporate taxes, encouraging higher production levels and shifting the AS curve to the right.

Leftward Shifts in AS Curve

1. Example: Oil Price Shock: The 1973 oil crisis led to increased production costs worldwide, shifting the AS curve to the left.
2. Example: Natural Disasters: Events like hurricanes can disrupt production, increasing costs and shifting the AS curve to the left.

Long-Term Changes

1. Long-Run Economic Growth: Over time, factors like technological advancements can cause a gradual rightward shift in the AS curve, representing long-term economic growth.

AD Curve

AD (Aggregate Demand): The AD curve shows the total quantity of goods and services that consumers, businesses, and the government are willing to buy at different price levels in an economy.

Factors Affecting the AD Curve

1. Consumer Spending: Higher consumer confidence leads to increased spending, shifting the AD curve to the right.
2. Interest Rates: Lower interest rates encourage borrowing and spending, shifting the AD curve to the right.
3. Government Spending: Increased government spending on public projects can also shift the AD curve to the right.
4. Exchange Rates: A weaker domestic currency can make exports cheaper, increasing demand and shifting the AD curve to the right.

Rightward Shifts in AD Curve

1. Example: Economic Stimulus: In 2020, the U.S. government issued stimulus checks, increasing consumer spending and shifting the AD curve to the right.
2. Example: Interest Rate Cuts: Central banks often lower interest rates during recessions to encourage spending, shifting the AD curve to the right.

Leftward Shifts in AD Curve

1. Example: Economic Crisis: The 2008 financial crisis led to decreased consumer spending and a leftward shift in the AD curve.
2. Example: Tax Increases: Higher taxes can reduce disposable income, decreasing consumer spending and shifting the AD curve to the left.

Long-Term Changes

1. Demographics: An aging population may save more and spend less, causing a long-term leftward shift in the AD curve.

Inflationary Gap

An inflationary gap occurs when the actual output (Real GDP) of an economy exceeds its potential output. In simpler terms, it’s when the economy is producing more goods and services than it can sustain in the long run. This often leads to rising prices, or inflation, because demand outstrips supply.

How Does it Appear on the AS/AD Diagram?

In the Aggregate Supply (AS) and Aggregate Demand (AD) diagram, the point where the AS and AD curves intersect represents the economy’s current state. The Long-Run Aggregate Supply (LRAS) curve represents the economy’s potential output. When the AD curve intersects the AS curve to the right of the LRAS curve, an inflationary gap exists. This means the economy is overheating, producing more than its sustainable capacity.

Real-World Examples

1. Dot-Com Bubble: In the late 1990s, excessive investment in internet-based companies led to an inflationary gap. The economy was producing and investing more than it could sustain, leading to inflation and eventually a market crash.
2. Housing Bubble in 2008: Leading up to the 2008 financial crisis, there was a surge in housing prices and construction. The economy was operating beyond its sustainable level, causing inflation in housing prices, which eventually led to a crash.

Why is it a Concern?

An inflationary gap is problematic for several reasons:

1. Rising Prices: As demand outstrips supply, prices go up, making everyday items more expensive for consumers.
2. Unsustainable Growth: The economy can’t operate beyond its potential for long without negative consequences like market crashes.
3. Policy Interventions: Governments may need to intervene by reducing spending or increasing interest rates, which can slow down the economy and lead to job losses.