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AD AS Model

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Economics

When you go to a gas station to put gasoline in your car and you notice that, due to a global event decreasing the availability of oil, the price of gasoline is going up, do you behave differently? Do you buy fewer gallons of gas? What else in our economy is affected by the global increase in oil prices?

If the FED decides to decrease the interest rate, is that a good thing or a bad thing?

Why do prices rise when employees become less productive?

You can answer all these questions and more using the AD-AS model. This article will help you learn everything you need to know about the AD-AS model.

AD-AS model definition

The AD-AS model is a model in which all goods and services of an economy are modeled as one marketplace, with an aggregate demand curve and an aggregate supply curve.

During the 1970s, the aggregate supply curve shifted to the left, increasing the aggregate price level in the US economy. On the other hand, when the 2008 financial crisis hit the economy of the United States, the aggregate demand shifted to the left, causing a decrease in the level of output associated with a fall in price levels.

There can many periods in which an economy deviates from its equilibrium level of output. Many factors could cause an economy to temporarily shift from its equilibrium output—however, one common thing for all these fluctuations is in either the aggregate demand or aggregate supply curve.

The AD-AS model brings together the aggregate demand and supply to understand and analyze economic fluctuations. AD-AS model aims to capture short-run and long-run effects of a shift in either aggregate demand or aggregate supply.

AD-AS model graph

AD AS Model, AD-AS model graph, StudySmarterFigure 1. AD-AS model graph - StudySmarter

Figure 1 illustrates the AD-AS model. In this graph, notice three important curves: Aggregate demand (AD), Short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS).

Aggregate demand refers to the total demand for goods and services within the economy. It consists of consumption, investment, government spending, and net exports. For more details on aggregate demand, check our explanation.

As the name suggests, short-run aggregate supply (SRAS) refers to the supply of companies in the short run.

Long-run aggregate supply (LRAS) refers to the full employment level of real output, the total amount of goods and services, and the economy can produce using its entire resources. The LRAS curve is also called potential output, because it is considered the economy's capacity.

The AD-AS model suggests that there is a short-run macroeconomic equilibrium and a long-run macroeconomic equilibrium. Short-run macroeconomic equilibrium occurs when the aggregate demand equals the short-run aggregate supply. If one of those curves were to shift due to any external factor besides the aggregate price or the GDP, the short-run macroeconomic equilibrium would form at that point.

Short-run macroeconomic equilibrium is the intersection of AD and SRAS.

On the other hand, long-run macroeconomic equilibrium occurs when the intersection between all three curves, AD, SRAS, and LRAS, occurs. Keep in mind that whenever there’s a shift in AD or SRAS, the economy will always tend to converge towards the long-run macroeconomic equilibrium. This means that the full-employment output is more static. The full-employment output can only change if there’s a change in LRAS.

Long-run macroeconomic equilibrium is the intersection of AD, SRAS, and LRAS.

We said that the equilibrium in the AD-AS model could change only when there’s a change in one of the three main curves. Let’s consider some of the factors that can shift these curves.

AD-AS Model: Shifts in aggregate demand

An event capable of shifting the aggregate demand curve is known as a demand shock. There are two main types of aggregate demand shocks, positive and negative. As Figure 2 suggests, a positive demand shock shifts the demand curve to the right, where the equilibrium occurs at a higher level of GDP, higher employment, and a higher aggregate price level.

AD AS Model, A positive demand shock shown in graph, StudySmarterFigure 2. A positive demand shock - StudySmarter

On the other hand, a negative demand shock shifts the aggregate demand curve to the left. At the new short-run equilibrium in this case, there is a lower aggregate price level, lower employment, and a lower output level.

The main factors that cause a shift in the aggregate demand curve include:

  • Consumer spending. An increase in consumer spending shifts the demand curve to the right, whereas a decrease in consumer spending shifts the demand curve to the left. Any factor that affects consumer spending can also influence and shift the AD curve. For instance, if the interest rate were to rise unexpectedly, it would cause consumer spending to decrease as they would want to save more rather than spend. This would shift the aggregate demand curve to the left.

  • Investment spending. Whenever there is an increase in investment spending in the economy, the AD curve will shift to the right. On the other hand, a decrease in investment spending would cause the AD curve to shift to the left. Any factor that influences investment spending can influence the AD curve. For example, if there are negative expectations about future investment returns, it will cause the investment spending to fall; hence, the AD curve shifts to the left.

  • Government spending. An increase in government spending causes the AD curve to shift to the right, whereas a decrease in government spending causes the AD curve to shift to the left. Again, any factor that affects government spending will also impact the AD curve. If the U.S government goes to war, the AD will shift to the right, and prices will rise in the economy.

  • Net exports. Net exports also shift the aggregate demand curve. An increase in net exports will cause the AD curve to move to the right and vice versa.

AD-AS Model: Shifts in short-run aggregate supply

A factor or event that causes a shift in the short-run aggregate supply is a supply shock. Supply shocks can be positive or negative. A positive supply shock causes the short-run supply curve to shift to the right, which results in higher output, higher employment, and lower prices. On the other hand, a negative supply shock causes the short-run supply curve to move to the left, which results in lower production, lower employment, and higher prices.

AD AS Model, A negative supply shock shown in graph, StudySmarterFigure 3. A negative supply shock - StudySmarter

Figure 3 shows the effect of a negative supply shock. As a result of this supply shock, the GDP drops, and the aggregate price level increases. An important thing to note here is that whenever you have a negative supply shock, which comes with a fall in output and price increase, the economy is in stagflation.

Stagflation is a period of increasing prices coupled with decreasing output.

Many factors cause a supply shock. Main types of supply shocks include:

  • Commodity prices. Whenever there is an increase in commodity prices, the SRAS curve will shift to the left. This is because commodities are often inputs to the production process. If commodity prices rise, then production costs are higher. On the other hand, whenever the prices of commodities decrease, production is cheaper and the SRAS shift to the right.

  • Nominal wages. Nominal wages are also capable of influencing, or shifting, the SRAS curve. Whenever there is an increase in nominal wages, the SRAS shifts to the left. This is because labor is another input in the production process.

  • Productivity. Productivity is also capable of influencing the SRAS curve. A fall in productivity means each worker can produce fewer units, so there is less production overall; hence, the SRAS shifts to the left. An increase in productivity means that the total level of output produced by a firm increases, which on an aggregate level, causes the SRAS to shift to the right.

Relationship between inflationary gaps in the AD-AS model

An inflationary gap is something that can be modeled using the AD-AS model. It occurs when there is a shift in the short-run equilibrium that involves more output and higher prices. The output gap is the difference between the new higher actual output and the potential output, which is defined by the LRAS.

AD AS Model, Inflationary Gaps and AD-AS model shown in graph, StudySmarterFigure 4. Inflationary gap and AD-AS model - StudySmarter

Figure 4 shows one example of an inflationary gap and AD-AS model. Assume that the economy is initially in Equilibrium E1, where Real GDP is Y1 and the aggregate price level in the economy is P1. As a result of a positive demand shock, the model results in a new equilibrium at E2. Now there are higher prices, a higher level of output, and an inflationary gap.

An inflationary gap is when you have actual output at a higher level than the potential, or long-run, output.

Figure 4 illustrated an inflationary gap in which aggregate demand shifted right. Another possibility is that the SRAS curve shifts right. In both cases, aggregate output increases, and there is an inflationary gap.

Alternatively, if aggregate demand shifts left, or SRAS shifts left, then the new actual output is lower than the potential, or long-run output. The output gap is now negative. In this case, the difference between Y1 and Y2 is called a recessionary gap.

A recessionary gap is when you have actual output at a lower level than the potential, or long-run, output.

Monetary policy in the AD-AS model

Monetary policy is carried out by the Federal Reserve, which can raise or lower interest rates. Monetary policy plays an important role in the AD-AS model. Monetary policy has a huge impact on the number of loanable funds available and the interest rate in the economy, which in turn affect several components of the aggregate demand (AD) curve.

When there is expansionary monetary policy, meaning interest rates are lowered, the aggregate demand shifts to the right, and when there is a contractionary monetary policy, meaning interest rates are raised, the AD curve shifts to the left.

Let’s consider the case when there is an expansionary monetary policy.

AD AS Model, Monetary policy in the AD-AS model shown in graph, StudySmarterFigure 5. Monetary policy in the AD-AS model - StudySmarter

Figure 5 shows the scenario that happens in the event of an expansionary policy by the FED.

Expansionary monetary policy comes in the form of lowering interest rates, which spurs consumer spending and investment spending to increase in an economy. This shifts the AD curve to the right. The equilibrium shifts from E1 to E2. The new equilibrium results in higher prices and a higher level of GDP. This is a short-run effect.

What happens next? As prices increase, people will demand higher wages to match the aggregate price increase in the economy. Higher wages will cause the SRAS to shift to the left, and there will be a new equilibrium at E3. At this point, the equilibrium occurs at the full employment level of output but at a higher aggregate price level.

Whenever the economy returns to the potential output, we say that the economy is self-correcting. This means that shocks in aggregate demand can affect the economy in the short run but not in the long run.

AD-AS model example

A good example of the AD-AS model is the increase in oil prices experienced by economies around the world starting in April of 2022. The increase in oil prices makes companies' production more expensive, which causes the short-run aggregate supply to shift to the left. This results in higher prices and a lower level of output. This causes a recession as the total output in the economy falls. This type of recession is known as stagflation, and it is one of the hardest ones to address.

AD-AS Model - Key Takeaways

  • The AD-AS model brings together the aggregate demand curve and the aggregate short-run supply and long-run aggregate supply.
  • A demand shock or supply shock can be positive or negative.
  • The main factors that cause a shift in the aggregate demand curve include: consumer spending, investment spending, government spending, net exports.
  • The main factors that cause a supply shock include: commodity prices, nominal wages, and productivity.
  • When you have a negative supply shock such that output falls and aggregate prices increase, the economy is in stagflation.
  • An inflationary gap is the difference between actual output and potential output when actual is higher, and a recessionary gap is the difference between potential output and actual output when potential output is higher.

AD AS Model

The AD-AS model brings together the aggregate demand and supply to understand and analyze economic fluctuations.  

In the AD-AS model, a recession occurs when aggregate demand (AD) or short-run aggregate supply (SRAS) shift to the left. The effect of this change is lower output in the short-run equilibrium outcome.

Any factor that can shift the aggregate demand or aggregate supply. For aggregate demand, this includes consumer spending, investment spending, government spending, and net exports. For aggregate supply this includes commodity prices, nominal wages, and productivity.

The real GDP and the aggregate price level in the economy.

The aggregate demand and aggregate supply (AD-AS) model explains changes in the real GDP and aggregate price level.

Final AD AS Model Quiz

Question

Define AD-AS model?

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Answer

The AD-AS model brings together the aggregate demand and supply to understand and analyze economic fluctuations.  

Show question

Question

What is the aim of AD-AS model?

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Answer

 AD-AS model aims to capture short-run and long-run effects of a shift in either aggregate demand or aggregate supply. 

Show question

Question

At which point the short-run macroeconomic equilibrium occurs?

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Answer

Short-run macroeconomic equilibrium occurs when the aggregate demand equals the short-run aggregate supply. If one of those were to shift due to any external factor besides the price and level of (GDP), the short-run macroeconomic equilibrium would form at that point.

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Question

When does the long-run macroeconomic equilibrium occur?

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Answer

Long-run macroeconomic equilibrium occurs when the intersection between all the three curves, AD, SRAS, and LRAS, occurs. Keep in mind that whenever there’s a shift in AD or SRAS, the economy will always tend to converge towards the long-run macroeconomic equilibrium.

Show question

Question

What's a demand shock?

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Answer

An event capable of shifting the aggregate demand curve is known as a demand shock. 

Show question

Question

What are the two types of demand shock?

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Answer

There are two main types of aggregate demand shocks, positive and negative. 

Show question

Question

How does a positive demand shock affects the aggregate demand curve?

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Answer

A positive demand shock shifts the demand curve to the right, where the equilibrium occurs at a higher level of GDP and higher prices.

Show question

Question

How does a negative demand shock affect the aggregate demand curve?

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Answer

A negative demand shock shifts the aggregate demand curve to the left, where equilibrium occurs at lower prices and lower output levels.

Show question

Question

What are the main factors that can cause a shift in the AD curve?

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Answer

Main factors that cause a shift in the aggregate demand curve include: consumer spending, investment spending, government spending, net exports.

Show question

Question

What is a supply shock?

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Answer

A factor or event that causes a shift in the Short Run Aggregate Supply is a supply shock.

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Question

What are the two types of supply shocks?

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Answer

Positive supply shock and negative supply shock.

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Question

What is stagflation?

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Answer

Whenever you have a negative supply shock, which comes with a fall in output and price increase, the economy is in stagflation.

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What are the main causes of supply shocks?

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Answer

Main types of supply shocks include: commodity prices, nominal wages, and productivity.

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Question

What are the two types of output gap?

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Output gap refers to the difference between actual and potential output(defined by the LRAS). Two types of output gaps include: recessionary output gaps and inflationary output gaps.

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What is an inflationary gap?

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The inflationary gap refers to when you have the actual output at a higher level than the potential output. 

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Question

What's the relationship between inflationary gaps and AD-AS model?

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Answer

The relationship between the inflationary gap and AD-AS model can be observed when there is a shift in the equilibrium of the AD-AS model, and it is associated with higher output and higher prices.

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Question

What's the relationship between monetary policy and AD-AS model?

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Answer

Monetary policy plays an important role in the AD-AS model. Monetary policy has a huge impact on the number of loanable funds available and the interest rate in the economy, which affect several components of the Aggregate Demand curve. 

Show question

Question

What happens when there is an expansionary monetary policy?

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Answer

Expansionary monetary comes with lower interest rates, which cause consumer spending and investment spending to increase in an economy. This, in turn, shifts the AD curve to the right. The new equilibrium results in higher prices and a higher level of GDP.

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Question

What is long run self adjustment?

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Answer

The long-run self-adjustment is the process through which the economy goes back to its equilibrium point after receiving a shock in the economy.

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Question

How does the economy self adjust in the long run when there is an inflationary gap?

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When there is an inflationary gap, the economy self adjusts by having a leftward shift the SRAS.

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Question

What happens in the long run in a recessionary gap?


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Answer

In the long run, after the self adjustment process, the prices decrease in the economy.

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Question

What happens in the long run when aggregate demand increases?


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The increase in aggregate demand will cause a price increase in the economy, which will cause the short run aggregate supply to shift to the left.

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Are prices sticky or flexible in the long run?

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Prices are flexible in the long run.

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Are prices sticky or flexible in the long run?

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Prices are flexible in the long run.

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Are wages sticky or flexible in the long run?

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Wages are flexible in the long run.

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Why is equilibrium in the long restored at full employment output?

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The equilibrium in the long run is restored at full employment output due to change in prices and wages.

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Why is equilibrium in the long restored at full employment output?

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The equilibrium in the long run is restored at full employment output due to change in prices and wages.

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What happens when there is a shift in long run aggregate supply?

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A shift in the long-run aggregate supply comes with a change in the full-employment level of output.

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What is the main idea behind the long run self adjustment?

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The main idea behind the theory of the long-run self-adjustment is that when the economy experiences fluctuations, it will go back to its full-employment output in the long run. That means that changes in the economy matter only in the short run. 

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What is one of the main benefits of long run self adjustment?

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There are many benefits of the long-run self-adjustment mechanism of the economy—one of the main ones being that the economy goes back to its full potential output. When a demand or supply shock occurs that causes fluctuations in the economy, there will be either a drop in production or an increase in output associated with inflation. 

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Question

Does the government get involved when there is a shock in the economy according to the long-run self-adjsutment?

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No the government does not interfere. The equilibrium is restored due to market forces.

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What are recessionary gaps?

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Recessionary gaps are periods in the economy that are associated with a decline in the price level and the overall production in the economy. 

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What is an output gap?

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An output gap is a difference between actual aggregate output and potential output. 

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What are inflationary gaps?

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Answer

Inflationary gaps are periods in the economy that are associated with an increase in the price level and the overall production in the economy.

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Question

Briefly explain the AD-AS model.

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Answer

The AD-AS model is a model that is based on two key variables of the economy. The first variable considered is the economy's production of goods and services, which is measured by real gross domestic product. 

The second factor is the average level of prices, for which a proxy used is the Consumer Price Index (CPI).

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Is price level in the AD-AS model a real variable?

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Answer

No the price level in the AD-AS model is a nominal variable.

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Is output in the AD-AS model a real variable?

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Yes output is a real variable in the AD-AS model.

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When does equilibrium in the AD-AS model occur?

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The equilibrium in the AD-AS model occurs at the point where aggregate demand equals aggregate supply.

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What happens when the AD-AS curves intersect?

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At the point of equilibrium in the AD-AS model, the price level in the economy and the level of total production captured by GDP are in equilibrium. 

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Question

What are the three main determinants of the equilibrium in the AD-AS model?

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Answer

There are three main determinants of the AD-AS model, including aggregate demand, short-run aggregate supply, and long-run aggregate supply.

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What is aggregate demand?

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Answer

Aggregate demand is the demand for all goods and services in an economy. The entire amount of money traded for such products and services at a certain price level and moment in time is referred to as aggregate demand.

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What does aggregate demand consist of?

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The aggregate demand consists of consumption, investment, government spending, and net exports. 

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What is short run aggregate supply?

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Short-run aggregate supply is the total supply of goods and services in the economy at a certain time and a certain price. The short-run aggregate supply has a positive relationship with the price level, meaning an increase in the price level also increases the quantity supplied and vice versa.

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Question

What is long run aggregate supply?

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Long-run aggregate supply refers to the entire production that could occur in an economy when the economy uses all its production resources efficiently. 

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Question

What's the difference between short run equilibrium and long run equilibrium in the AD-AS model?

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Answer

The short-run equilibrium occurs when aggregate demand and short-run aggregate supply intersect. 

Long-run equilibrium in the AD-AS model occurs when all of the three determinants intersect.

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Question

What kind of output gap there is when the short run equilibrium is below the full employment output?

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Answer

Negative output gap (recessionary gap)

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What kind of output gap there is when the short run equilibrium is above the full employment output?

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Positive output gap (inflationary gap)

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Question

What are the factors that cause a shift in aggregate demand?

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Answer

Reasons why the aggregate demand might shift include income, interest rates, inflation expectation, and exchange rate.

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Question

What are the factors that cause a shift in short run aggregate supply?

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Answer

Reasons why the short-run aggregate supply shifts include: cost of inputs, labor productivity, and technological advancements.

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