AD/AS and the

SUPPLY AND DEMAND MODEL

Our purpose is to illustrate how the supply and demand model can describe the macro product market.

One of the impressive things about the supply and demand model is how many different kinds of situations it can describe. It has many uses.

1. x increases => p and q both increase

We can start with the following observations:

An increase of desired spending causes inflation and real growth to rise.

2. x decreases => p and q both decrease

These are both examples of a “Change in Demand”

We can say, “ A change of demand causes inflation and real growth to move in the same direction.”

x p q

6 3 3

9 4 5

We want to draw a picture of this numerical example. The example asserts that if spending (aka Aggregate Demand, aka nominal GDP) is growing at 6%, we will have inflation (p) of 3% and real growth (q) of 3%. Recall that x = p + q

We will often use these values as a starting point. The numbers are close to the averages for the US (The actual numbers are a bit less than this.)

We furthermore want our example to assert that if x increases to 9%, we get p = 4 and q = 5.

We will now summarize these observations on the form of a supply and demand graph:

Draw and label the axes.p

q

Real growth (q) is always on the horizontal (x-axis)

Inflation (p) is always on the vertical (y-axis)

Draw a downward sloping 45° line; label it AD

p

qDraw a upward sloping line; label it AS

AD

AS

Mark the point of intersection. This will be the market’s “equilibrium.”

q0

p0

p

qAD

AS

3

3

x p q

6 3 3

We would expect both p and q to rise. Let’s say they rise to q = 5% and p = 4%

9 4

Suppose x (aggregate spending) now begins to rise at a rate of 9%

5

We can start with our example of x = 6%, with p and q both equal to 3%

p

qAD0

AS

3

3

Here’s how the graph illustrates this.

x p q

6 3 3

9 4 5

Move the AD curve up and to the right to illustrate an “increase of demand.”

AD1

Look at the point of intersection. It has moved to the right (q has risen) and up (p has risen). This is what we were trying to picture. When x (Spending/Aggregate Demand) rose, both inflation and real growth increased.

5

4

Using no numbers we can make the general statement:

When AD rises, inflation and real growth both rise

p

qAD0

AS

q0

p0AD1

q1

p1

We can say and graph the opposite result

When AD falls, inflation and real growth both fall.

p

qAD1

AS

q1

p1AD0

q0

p0

1. An increase of the cost of production – with no change of spending -- will cause inflation to rise and real growth to fall

Let us now graph another set of observations:

2. A decrease of the cost of production – with no change of spending -- will cause inflation to fall and real growth to rise.

More generally, a change of supply causes inflation and real growth to move in opposite directions.

As numerical examples we can use the following:

An increase of Aggregate Supply caused by:

x p q

6 3 3

6 2 4

1. a decreased price of a FOP, or2. an increased quantity of a FOP

3. an increased quality of a FOP

x p q

6 3 3

6 4 2

An decrease of Aggregate Supply caused by:

1. an increased price of a FOP, or2. a decreased quantity of a FOP

3. a decreased quality of a FOP

To illustrate an increase of Aggregate Supply:

shift the AS curve to the right

p

qAD

AS0

q0

p0

q1

p1

AS1

p

qAD

AS1

q1

p1

q0

p0

AS0

To illustrate a decrease of Aggregate Supply shift the AS curve to the left

These look backwards to a lot of people!!

AS => p,q

AS => p,q

AD => p,q

AD => p,q

LEARN THESE FOUR LAWS AND THE GRAPHS THAT GO WITH EACH OF THEM