AD-AS-LRAS Model

The AD-AS model has no single originator. It grew out of attempts in the 1960s and 1970s to add price-level dynamics to the IS-LM framework, drawing on both Keynesian demand analysis and classical supply reasoning.

The model tackles a core question: why does unemployment persist if prices can adjust? AD-AS answers by separating short-run behavior (prices are sticky, so demand drives output) from long-run behavior (prices are flexible, so supply determines output at the natural rate).

AD-AS proved especially useful after the 1970s stagflation, which a simple Phillips-curve tradeoff could not explain. A leftward shift in short-run aggregate supply raises the price level and lowers output simultaneously - exactly what happened when oil prices spiked.

The AD curve slopes downward: a higher price level reduces real money balances, raising interest rates and crowding out investment and consumption. Each point on the curve is an IS-LM equilibrium at a given price level.

The short-run AS curve slopes upward because wages and some prices are sticky. When the overall price level rises unexpectedly, firms with fixed nominal wages see higher margins and expand output. In the long run, wages catch up, and the AS curve is vertical at potential output.

Short-run dynamics work like this: a demand shock slides the economy along the upward-sloping AS curve, changing both output and the price level. Over time, wage and price adjustment shifts the short-run AS curve until the economy returns to the vertical long-run level.

Central banks face a choice after a supply shock. An oil price spike shifts short-run AS left, raising prices and cutting output. Accommodating the shock (holding policy loose) accepts higher inflation; fighting it (tightening) accepts deeper output loss. AD-AS maps these tradeoffs.

Fiscal stimulus works through the AD curve. In a recession, output sits below potential. A spending increase shifts AD right, raising output toward the natural rate. The price-level increase is small when the economy has slack, larger when it is near capacity.

In the long run, output returns to the natural rate regardless of demand policy. Trying to hold output permanently above potential requires ever-faster money growth and accelerating inflation - the logic behind modern inflation-targeting regimes.