121 Business Cycles and Growth in the AD–AS Model
Learning Objectives
- Use the aggregate demand-aggregate supply model to explain recessions, expansions and economic growth
- Explain how unemployment and inflation can be explained using the aggregate demand-aggregate supply model
- Evaluate the importance of the aggregate demand-aggregate supply model
Business Cycles in the AD-AS Model
Business cycles represent the slowing down, declining and speeding up of the economy, or more formally, recessions and expansions. The AD-AS model gives us one way to understand business cycles. Recessions occur as a result of negative demand or supply shocks, which cause the equilibrium level of real GDP to fall substantially below potential GDP, as occurred at the equilibrium point E1 in Figure 1.
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Unemployment in the AD–AS Diagram
Recall that cyclical unemployment is unemployment to fluctuates with the business cycle. In the AD–AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full employment level of GDP. Returning to Figure 1 above, cyclical unemployment increases when the output falls substantially below potential GDP on the AD–AS diagram, as at the equilibrium point E0.
Expansions occur as a result of positive demand or supply shocks, which cause the equilibrium level of real GDP to rise towards, and sometimes beyond, potential GDP, as occurred at the equilibrium point E1 in Figure 2. As GDP rises, cyclical unemployment falls.
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Inflationary Pressures in the AD–AS Diagram
Inflation fluctuates in the short run. Higher inflation rates have typically occurred either during or just after economic booms: for example, the biggest spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation decline during recessions. As an extreme example, inflation actually became negative—a situation called “deflation”—during the Great Depression. Even during the relatively short recession of 1991–1992, the rate of inflation declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short recession of 2001, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007–2009, the rate of inflation declined from 3.8% in 2008 to –0.4% in 2009. Some countries have experienced bouts of high inflation that lasted for years. In the U.S. economy since the mid–1980s, inflation does not seem to have had any long-term trend to be substantially higher or lower; instead, it has stayed in the range of 1–5% annually.
The AD–AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the AS curve. In Figure 3(a), there is a shift of aggregate demand to the right; the new equilibr