AP Macroeconomics The AS/AD Model FRQ – 2011 #1; 2011B #1; 2010 #1; 2010B #1; 2009B #1; 2008B #1; 2007 #1; 2007B #1; 2006 #1; 2006B #1

LRAS – Long run aggregate supply The LRAS curve is a vertical line at an output level that represents the quantity of goods and services a nation can produce over a sustained period using all of its productive resources as efficiently as possible. LRAS = FE = Yf

LRAS – cont. Developing more and better resources or improving technology will shift the LRAS curve outward, but it will still be vertical. The LRAS curve represents a point on an economy’s production possibilities curve.

The AS/AD Model “Assume the economy is at equilibrium” of AS & AD determines current output (GDP R ) and the price level (PL) GDP R PL AD SRASLRAS YFYF P

Full Employment Full Employment equilibrium exists where AD intersects SRAS & LRAS at the same point. GDP R PL AD SRASLRAS YFYF P

Recessionary Gap A recessionary gap exists when equilibrium occurs below full employment output. GDP R PL AD SRAS LRAS YFYF P Y gapgap

Inflationary Gap An inflationary gap exists when equilibrium occurs beyond full employment output. GDP R PL AD SRASLRAS YFYF P Y gapgap

Changes (Δ) in AD Δ Consumption (C) – C↑.: AD .: GDP R ↑ & PL↑.: u%↓ & π%↑ – C↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓ Δ Gross Private Investment (I G ) – I G ↑.: AD .: GDP R ↑ & PL↑.: u%↓ & π%↑ – I G ↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓ Δ Government Spending (G) – G↑.: AD .: GDP R ↑ & PL↑.: u%↓ & π%↑ – G↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓ Δ Net Exports (X N ) – X N ↑.: AD .: GDP R ↑ & PL↑.: u%↓ & π%↑ – X N ↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓

Increase in AD C↑, I G ↑, G↑ and/or X N ↑.: AD .: GDP R ↑ & PL↑.: u%↓ & π%↑ GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1   

Decrease in AD C↓, I G ↓, G↓ and/or X N ↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓ GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1   

Changes (Δ) in SRAS Δ Input Prices – Input Prices↓.: SRAS .: GDP R ↑ & PL↓.: u%↓ & π%↓ – Input Prices↑.: SRAS .: GDP R ↓ & PL ↑.: u%↑ & π%↑ Δ Productivity – Productivity↑.: SRAS .: GDP R ↑ & PL↓.: u%↓ & π%↓ – Productivity↓.: SRAS .: GDP R ↓ & PL ↑.: u%↑ & π%↑ Δ Legal-Institutional Environment – Deregulation.: SRAS .: GDP R ↑ & PL↓.: u%↓ & π%↓ – Regulation.: SRAS .: GDP R ↓ & PL ↑.: u%↑ & π%↑

Increase in SRAS Input Prices↓, Productivity↑, and/or Deregulation.: SRAS .: GDP R ↑ & PL↓.: u%↓ & π%↓ GDP R PL AD SRAS LRAS YFYF P Y SRAS 1 P1P1   

Decrease in SRAS Input Prices↑, Productivity↓, and/or Regulation.: SRAS .: GDP R ↓ & PL↑.: u%↑ & π%↑ GDP R PL AD SRAS LRAS YFYF P Y1Y1 SRAS 1 P1P1   

The economy isstagnating butinflating [“bad news” – job losses; “bad news” – inflation] AD AS 1 Y*Y*Y*Y* 10 % AS 2 “Stagflation” 10 % PL 1 LRAS Stag nating Inflating

AS / AD Summary ΔC, ΔI G, ΔG, and/or ΔX N = Δ AD – AD .: GDP R ↑ & PL↑.: u%↓ & π%↑ – AD .: GDP R ↓ & PL↓.: u%↑ & π%↓ Δ Input Prices, Δ Productivity, and/or Δ Regulation = Δ SRAS – SRAS .: GDP R ↑ & PL↓.: u%↓ & π%↓ – SRAS .: GDP R ↓ & PL ↑.: u%↑ & π%↑ The AS/AD Model is the most important graph in AP Macroeconomics. KNOW IT!!!

AD-AS Model Practice Questions Use an appropriately labeled AD-AS model to illustrate the impact of each of the following events on price level, output, and unemployment.

Practice Question #1 full employmentgovernment spending (G) increases Assume the economy is in equilibrium at full employment. If government spending (G) increases due to an outbreak of war, what is the impact of the spending on price level, output, and unemployment? What economic condition or problem results? ____ ____ Price Level ____ Output ____ Unemployment Problem: Price Level Real GDP (GDP R ) SRAS AD 1 PL F YFYF LRAS AD AD 2 PL 2 Y2Y2

Practice Question #2 full employmentconsumer indebtedness rises Assume the economy is in equilibrium at full employment. If consumer indebtedness rises, what is the impact of the indebtedness on the price level, output, and unemployment? What economic condition or problem results? Price Level Real GDP (GDP R ) SRAS AD 1 PL F YFYF LRAS ____ ____ Price Level ____ Output ____ Unemployment Problem: AD 2 PL 2 Y2Y2AD

Practice Question #3 full employment OPEC restricts the supply of oil and raises energy costs across the economy Assume the economy is in equilibrium at full employment. If OPEC restricts the supply of oil and raises energy costs across the economy, what is the impact of the higher production costs on price level, output, and unemployment? What economic problem/condition results? Price Level Real GDP (GDP R ) SRAS 1 AD PL F YFYF LRAS ____ ____ Price Level ____ Output ____ Unemployment Problem: SRAS 2 PL 2 Y2Y2 AS

1970’s Gas Crisis

Practice Question #4 recession government reduces personal income taxes, Assume the economy is in a recession. If government reduces personal income taxes, what is the impact of the tax cut on price level, output, and unemployment? What economic condition may result? Price Level Real GDP (GDP R ) SRAS LRAS AD 1 PL 1 Y1Y1 ____ ____ Price Level ____ Output ____ Unemployment Condition: YFYF AD 2 PL FAD

Practice Question #5 the FED increases interest rates by reducing the money supply, Assume the economy is overheated and experiencing serious demand-pull inflation. If the FED increases interest rates by reducing the money supply, what will be the impact of the FED action on the price level, output, and unemployment? What problem or condition may result? Price Level Real GDP (GDP R ) SRAS LRAS AD 1 Y1Y1 PL 1 ____ ____ Price Level ____ Output ____ Unemployment Condition: AD 2 PL F YFYFAD

Practice Question #6 full employmentproductivity increases Assume the economy is in equilibrium at full employment. If productivity increases due to technological developments, what is the impact of the increased productivity on the price level, output, and unemployment? Price Level Real GDP (GDP R ) SRAS 1 AD PL F YFYF LRAS ____ ____ Price Level ____ Output ____ Unemployment SRAS 2 PL 2 Y2Y2Y2Y2AS

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