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The ASAD model

When you use an upward sloping AS curve rather than a horizontal “short run” and vertical “long run” AS curve it allows you to see much better what the short and medium run effects of various policies which affect aggregate supply and demand in the economy.

The key to understanding this is the concept of the short and medium run in the context of economic fluctuations. There are two things which basically define this:

1. There will be a natural level of output which is ultimately determined by the economy’s supply potential. In the short run you can be above or below it, but in the medium run you will end up tending back there. If the supply potential of the economy increases then the natural level will increase – I guess that’s how you can describe economic growth, a gradually increasing natural level of output around which there will be short run fluctuations. Blanchard uses the term ‘long run’ to deal with issues regarding economic growth over time, the medium run is the time it takes to return from a fluctuation above or below the natural level, back to the natural level, and the short run is the time you can fluctuate around the natural level.
2. The price system will ultimately be the mechanism by which you get from the short run to the medium run, ie by which you return to the natural level. When you have output above the natural level of output as determined by the supply potential in the economy, you are going to get upward pressure on prices, that will create inflation, which will push up wage demands, firms will pass on the costs of higher wages in terms of higher prices and everything will be more expensive, so your output will start to creep back towards the natural level. This will be represented by the AS curve shifting upwards. In terms of prices, the key point is price expectations. In the medium run, expected prices will always be in line with actual prices. In the short run, expected prices can be above or below actual prices, and the price mechanism will basically move to bring expectations in line with reality.

This is actually simple to understand when you draw the ASAD model, and realise how to use it.
You have price on the vertical axis, output on the horizontal axis. You have an upward sloping AS curve and a downward sloping AD curve. The point where they intersect will tell you the equilibrium level of output and price level in the economy.

Here we are starting at a medium-run equilibrium, output is at the natural level (Yn) and prices are at the level where expected prices equal actual prices.

Now for how to use this model…

The AS curve shifts up if expected prices rise or if there is a negative supply shock (eg an increase in firms’ costs which increases the mark-up the place on prices over wage costs). It shifts down if expected prices fall or if there is a positive supply shock.

The AD curve shifts out to the right if you have a monetary or fiscal expansion or an increase in consumer confidence. It shifts in if you have a monetary or fiscal contraction or a decrease in consumer confidence.

Whenever expected prices are out of step with actual prices, the AS curve will move in the direction of actual prices – this is the adjustment mechanism which gets you back to the medium run.

We can use the ASAD to analyse the short and medium run effects of various policies:
Fiscal expansion
Fiscal contraction
Monetary expansion
Monetary contraction
Supply side shocks

Categories: ASAD, Macro
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