Dynamic AD-AS Model: Inflation and Recession: Videos & Practice Problems

Inflation occurs when the overall price levels in an economy rise, typically due to aggregate demand increasing at a faster rate than aggregate supply. In the dynamic aggregate demand and aggregate supply (ADAS) model, this situation can be visualized through shifts in the respective curves. When total spending, represented by aggregate demand, outpaces total production, or aggregate supply, prices will inevitably rise. This imbalance is particularly evident in the short-run aggregate supply, which may not adjust as quickly as demand.

To illustrate this, consider a standard ADAS graph with the price level on the vertical axis and real GDP on the horizontal axis. Initially, the long-run aggregate supply (LRAS), short-run aggregate supply (SRAS), and aggregate demand (AD) are positioned at equilibrium. Over time, as the economy grows, these curves shift to the right, indicating an increase in potential GDP. However, if aggregate demand shifts significantly to the right while short-run aggregate supply only shifts slightly, a new equilibrium is established at a higher price level.

This scenario highlights the critical relationship between aggregate demand and supply: when aggregate demand increases substantially compared to short-run aggregate supply, inflation results. The new equilibrium reflects a higher price level, demonstrating that while GDP may rise, the cost of goods and services also escalates. Thus, the key takeaway is that a significant shift in aggregate demand relative to a smaller shift in short-run aggregate supply leads to inflationary pressures in the economy.

The Great Recession of 2007 to 2009 serves as a critical case study in understanding the dynamics of the Aggregate Demand-Aggregate Supply (ADAS) model. This period was marked by significant economic events that influenced both aggregate demand and supply, leading to a unique economic equilibrium characterized by rising prices and falling output.

One of the primary catalysts of this recession was the collapse of the housing bubble. The bursting of this bubble resulted in only a minimal increase in aggregate demand, which typically shifts to the right in a growing economy. However, the financial crisis that ensued further exacerbated the situation. The unavailability of credit due to the housing market crash meant that firms faced difficulties in securing loans for investment, leading to an even smaller rightward shift in aggregate demand.

Compounding these issues was a significant supply shock caused by soaring oil prices, largely driven by international competition, particularly from China. This increase in oil prices led to a leftward shift in the short-run aggregate supply (SRAS). It is important to note that while the long-run aggregate supply (LRAS) continues to increase over time due to factors like technological advancements and labor force growth, the short-run aggregate supply is more susceptible to temporary shocks such as rising oil prices.

In graphical terms, the initial equilibrium in 2007 can be represented with the long-run aggregate supply (LRAS) and short-run aggregate supply (SRAS) intersecting with aggregate demand (AD) at a certain price level. As the recession unfolded, the SRAS shifted significantly to the left, while the AD only increased slightly. This resulted in a new short-run equilibrium in 2008, where the intersection of the new SRAS and AD indicated higher price levels but lower real GDP, illustrating the dual impact of inflation and recession.

In summary, the 2007-2009 recession exemplifies how interconnected factors such as housing market dynamics, financial crises, and supply shocks can dramatically alter economic conditions. Understanding these shifts within the ADAS framework is essential for analyzing economic fluctuations and their implications for policy responses.