The AS/AD Model

The Aggregate Supply-Aggregate Demand model (AS/AD for short) is designed for analyzing the short-run behavior of a closed economy. The main feature of such an economy is the following cycle: output Y oscillates around its potential or full-employment level Y*. If Y is more than Y*, higher inflation is the result; if Y is less than Y*, unemployment is unnecessarily high. Stabilization policies ¿ monetary and fiscal ¿ aim at keeping Y as close as possible to Y* by manipulating aggregate demand (changing Y* is a long-run, supply-side, structural issue). The AS/AD model provides an easy understanding of the workings and effectiveness of stabilization policy measures. The key variables of the model (the endogenous variables) are output Y (assumed to be a good proxy for employment) and price level P. In some versions, the price level is replaced by the rate of inflation. The model can also be specified in terms of the actual and potential rates of output growth. In the standard textbook version, the model is built in three steps: first the aggregate supply curve; then the IS/LM curves which represent output and interest rate; and lastly the aggregate demand curve which plots output and price level. The intermediate step is omitted here.