Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Using the AD–AS Model to Analyse Shocks to the System


In This Chapter


Understanding the focus of the AD–AS model


Encountering demand-side impacts


Shocking the supply side
Like a jittery politician waiting to start a TV interview with a rottweiler of a journalist, the economy never stands still. For example, interest rates, government policy and consumer confidence are always changing, impacting the economy in different ways. Macroeconomists often call these changes shocks, probably because they can’t easily predict them. The Aggregate Demand–Aggregate Supply (AD–AS) model (which we discuss in detail in Chapters 7 and 8) comes into its own when you use it to analyse how macroeconomic shocks impact the economy.

In this chapter you discover how to use the AD–AS model to analyse different shocks as well as how they affect key macroeconomic variables, including inflation, unemployment and real GDP. More specifically, we discuss the following impacts:

On the demand side: Consumer and company confidence, fiscal and monetary policies, and the multiplier effect


On the supply side: Energy prices and technological advances


Discovering What the AD–AS Model Does and Doesn’t Explain
Although the AD–AS model is of great importance in macroeconomics, no single model attempts to explain everything.
In economic modelling, analysts make a key distinction between endogenous and exogenous variables:


Endogenous: Variables that the model attempts to explain


Exogenous: Variables determined outside the model

For example, in the AD–AS model, the price level and real GDP are endogenous variables (see Figure 9-1). The increase in aggregate demand from AD₁ to AD₂ (for some as-yet unspecified reason) has, in the short run, caused the price level to increase from P₁ to P₂ and real GDP to increase from Y₁ to Y₂. Thus the AD–AS model has ‘explained’ the change in the price level and real GDP: the increase in AD caused them both to increase.

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Figure 9-1: Price level and real GDP are endogenous variables in the AD–AS model.


The increase in AD could be the result of a number of changes in the economy, for example a fall in the interest rate or an increase in government spending. These two changes are examples of exogenous variables in the model, because the model doesn’t attempt to explain why the interest rate has changed or why the government has increased spending, it just uses the fact that it has.

So, in general, economic models can say how endogenous variables are affected by changes in exogenous variables. We’re not implying that macroeconomists are uninterested in what determines the interest rate or government spending, simply that explaining them requires a different model in which those variables are endogenous instead of exogenous.

Economists model in this way because building knowledge in economics is an incremental process. Instead of trying to work out in one go how an extremely complicated system such as the economy functions, it makes more sense to try slowly to understand a few things at a time!