AD/AS Diagram & Explanation

1. Increase in AD

General Price Level AS1

P
2
P
1
AD2
AD1

0 Y1 Real National Income

Y2

Figure 1
Impact on Economic growth and Unemployment

1. State assumption and initial equilibrium

 Assuming the economy is at the intermediate range of AS curve, indicating
some spare capacity in the economy,
 Initial equilibrium is where AD1 is equal to AS1 . Equilibrium general price
level is 0P1 and equilibrium real national income is 0Y1.
2. State change in AD and AD curve
 An increase in component of AD such as C , I results in an increase in AD
ceteris paribus.
 This results in a right shift of AD curve from AD1 to AD2.

3. Explain how diseqm UN ,eqmRNY

 Excess demand occurs at initial equilibrium general price level of 0P1.
 Rise in demand for firms’ goods and services lead to unplanned running
down of inventories.
 Firms increase production to replenish inventory stocks in the next time
period.
 To increase production, the firms hire more factors of production including
labour, thus reducing cyclical unemployment due to rise in derived
demand for labour and make more factor income payments to households,
increasing households’ income, triggering the multiplier process.
 [Multiplier process: Households spend part of the increase in income on domestic
goods and services which is re-injected into the domestic economy, generating
another round of increase in output, employment and income while the rest of the
increase in income leads to a rise in withdrawals in terms of savings, taxes and
spending on imports. This process continues till new equilibrium is reached at
higher equilibrium real national income. ]
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  Thus, via the multiplier effect , there is eventually a greater increase in
equilibrium real national income from 0Y1 to 0Y2 compared to the rise in
AD.

Impact on inflation:

1. State assumption and initial equilibrium

 Assuming the economy is at the intermediate range of AS curve, which
indicate some spare capacity in the economy,
 The economy was initially in equilibrium when AD1 is equal to AS .
Equilibrium general price level is 0P1 and equilibrium real national
income is 0Y1.

2. State change in AD and AD curve

 An increase in component of AD such an increase in C , I results in an
increase in AD ceteris paribus.
 This results in a right shift of AD curve from AD1 to AD2.

3. Explain how diseqmeqm GPL

 Excess demand occurs at initial equilibrium general price level of 0P1,

exerting upward pressure on general price level.
 Rise in demand for firms’ goods and services lead to unplanned running
down of inventories. Firms increase production to replenish inventory
stocks in the next time period.
 Since the economy is close to full employment, the firms compete for scarce
resources leading to bidding up of prices.
 This exerts upward pressure on general price level .
 The general price level rises till new equilibrium where AD2=AS is reached
at higher equilibrium GPL of 0P2.
 Demand-pull inflation occurs assuming persistent rise in AD.

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 2. Decrease in SRAS

General Price Level

AS2
P2
AS1
P
P
1
P
 
 
AD1
 P0
 0
P Y2 Y1 Yf Real National Output
0
Figure 2

Impact on Economic growth and Unemployment

1. State assumption and initial equilibrium

 Assuming the economy is at the intermediate range of AS curve, indicating
some spare capacity in the economy,
 Initial equilibrium is where AD1 is equal to AS1 . Equilibrium general price
level is 0P1 and equilibrium real national income is 0Y1.

2. State change in SRAS and AS curve

 An increase in price of factors of production leads to increase in unit COP
resulting in a fall in SRAS ceteris paribus.
 This results in an upward shift of AS curve from AS1 to AS2.

3. Explain how diseqm UN ,eqmRNY

 Excess demand occurs at initial equilibrium general price level of 0P1.
 This is because firms cut production to maintain profits.
 To cut production, the firms hire fewer factors of production including
labour, thus increasing unemployment and make less factor income
payments to households, decreasing households’ income.
 Thus, there is eventually a decrease in equilibrium real national income
from 0Y1 to 0Y2, thus resulting in negative actual economic growth.

{ Changes in AS: No multiplier process}

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Impact on inflation:

1. State assumption and initial equilibrium

 Assuming the economy is at the intermediate range of AS curve, which
indicate some spare capacity in the economy,
 The economy was initially in equilibrium when AD1 is equal to AS .
Equilibrium general price level is 0P1 and equilibrium real national
income is 0Y1.

2. State change in AS and AS curve

 An increase in price of factors of production leads to increase in unit COP
resulting in a fall in SRAS ceteris paribus.
 This results in an upward shift of AS curve from AS1 to AS2.

3. Explain how diseqmeqm GPL

 Excess demand occurs at initial equilibrium general price level of 0P1,
exerting upward pressure on general price level.
 Due to the rise in unit COP, higher prices are required to maintain profits
so firms pass on part of the increase in cost as increases in prices of goods
and services.
 Thus, general price level rises till new equilibrium where AD1=AS2 is
reached at higher equilibrium GPL of 0P2.
 Cost-push inflation occurs, assuming persistent rise in unit COP.

3. Increase in LRAS
4

General Price Level

 P1
P
P0
2
 
P AD1
0
0 Y1 Yf Y2 Yf”Real National Output

Impact on Economic growth and Unemployment

1. State assumption and initial equilibrium

 Assuming the economy is at the intermediate range of AS curve, indicating
some spare capacity in the economy,
 Initial equilibrium is where AD1 is equal to AS1 . Equilibrium general price
level is 0P1 and equilibrium real national income is 0Y1.

2. State change in LRAS and AS curve

 An increase in quantity or quality of factors of production or improvement
in technology results in an increase in productive capacity leading to an
increase in LRAS ceteris paribus.
 This results in a right shift of AS curve from AS1 to AS2.

3. Explain potential economic growth

 There is an increase in potential output or full employment level of income
from 0Yf1 to 0Yf2.
 Hence, in the long run, the economy can experience potential economic
growth

4. Explain actual economic growth and unemployment

 Excess supply occurs at initial equilibrium general price level of 0P1.
 This is because firms increase production to increase profits.
 To increase production, the firms hire more factors of production including
labour, thus decreasing unemployment due to rise in demand for labour
and make more factor income payments to households, increasing
households’ income.

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  Hence, there is a rise in equilibrium real national income in the long run
from 0Y1 to 0Y2, resulting in actual economic growth.

Impact on inflation:

1. State assumption and initial equilibrium

 Assuming the economy is at the intermediate range of AS curve, which
indicate some spare capacity in the economy,
 The economy was initially in equilibrium when AD1 is equal to AS .
Equilibrium general price level is 0P1 and equilibrium real national
income is 0Y1.

2. State change in LRAS and AS curve

 An increase in quantity or quality of factors of production or improvement
in technology results in an increase in productive capacity leading to an
increase in LRAS ceteris paribus.
 This results in a right shift of AS curve from AS1 to AS2.

3. Explain how diseqm eqm GPL

 Excess supply occurs at initial equilibrium general price level of 0P1,
exerting downward pressure on general price level.
 Thus, general price level falls till new equilibrium where AD1=AS2 is
reached at lower equilibrium GPL of 0P2.
 Negative rate of inflation, deflation, occurs, assuming sustained fall in
equilibrium general price level.

4. Explain the impact on demand-pull inflation

 An increase in LRAS can dampen demand-pull inflation by slowing down the
increase in general price levels, given persistent rises in AD.
 This is because the increase in productive capacity helps to reduce supply
constraints, thus slowing down the rise in competition for resources arising
from increases in AD.