Dynamic AD-AS Model: Inflation and Recession - Online Tutor, Practice Problems & Exam Prep

Inflation occurs when aggregate demand increases faster than short-run aggregate supply, leading to higher prices. Conversely, during the 2007-2009 recession, the housing bubble's collapse and financial crisis caused only a slight increase in aggregate demand, while rising oil prices significantly reduced short-run aggregate supply. This resulted in higher prices and lower GDP, illustrating the dynamic interplay between aggregate demand and supply in economic models. Understanding these shifts is crucial for grasping macroeconomic stability and the business cycle.

Dynamic AD-AS Model: Inflation

All right. Now let's see how inflation and recessions fit into our dynamic aggregate demand aggregate supply model. So let's start here with inflation. This is a situation where prices are rising, right? A situation where prices are rising. Inflation occurs where prices are rising. So, in our dynamic ADAS model, it occurs when our total spending, so the spending being aggregate demand, is increasing faster than total production, our aggregate supply. Okay? So that's the idea here and specifically short run aggregate supply, when we do it in this model. So think about it. There's more spending. People are trying to buy more stuff, but the production isn't keeping up. So the prices are going to go up because there's more demand than supply in that case. Alright?

So let's go ahead and draw our initial situation. We would have some sort of standard aggregate demand aggregate supply. Where we have our long run aggregate supply, our short run aggregate supply, and our aggregate demand. Okay? And we're I am going to put a one next to all of these because that's our original situation. And we've got our price level on the y-axis, and real GDP on the x-axis. Okay? Let me get out of the way so you see everything. So this is our initial situation here and we would have this price level, say, right here. Okay? And like we said in the ADAS model or the dynamic ADAS model, everything's going to shift to the right year over year.

Now, when we first saw this graph, everything shifted equally to have the same price level from 1 year to the next. However, if everything doesn't shift equally, that's when we have a situation like this where we're going to have inflation, or possibly recession. So here, we're going to start with the inflation. And this is, like I said, where total spending increases faster than total production. What we're going to do is we're going to shift our spending, our aggregate demand. We're going to shift it far to the right. We're going to do a big shift for the aggregate demand. So that's AD2. And remember, everything's shifting to the right. Our long-run aggregate supply can shift to the right as well. But what we're going to do is we're going to make the short-run aggregate supply only shift a little bit. So long-run aggregate supply, number 2. But short-run aggregate supply will only shift it just a little bit. So make it a smaller space in between those. Oh, well, we still want it to cross. So let's try and make it. There we go. Alright. So there's our short-run aggregate supply number 2. And now I know there's a lot of curves there. What are we looking for? Well, we just drew 3 new curves in the new color red. Right?

So the three red ones meet, that is our new equilibrium because that's our new short-run aggregate supply, our new long-run aggregate supply, and our new aggregate demand. Okay? So this is our new long-run equilibrium. But notice that the price level has gone up. And that's because, just like I said before, that the total spending, we shifted the aggregate demand curve a lot more than we shifted the short-run aggregate supply there. Okay? So GDP still increases year over year like we would expect with the dynamic model because we have that increase in our potential GDP. But we also see the increase in the price levels there. Okay. So the main thing here is 1, shift AD a lot. 2, shift short-run aggregate supply a little. Okay? And then, obviously, we're shifting long-run aggregate supply, as well. Now, it's not like a lot or a little. It's just to that new equilibrium. We're just shifting it to the right, okay? The big thing that leads to this price inflation is that aggregate demand shifting more than the short-run aggregate supply. Cool? So that's what leads to this higher price level. Let's go ahead and pause and let's talk about recessions in the next video.

Dynamic AD-AS Model: Recession

All right. So now, let's talk about recessions in the dynamic AD-AS model and we'll look at a specific example, the 2007-2009 recession. And what we're going to do is we're going to visualize it on the graph, but these are some important things that happened during the recession and we're going to take those points and turn them into factors on the graph. So the first one was the end of the housing bubble. Whenever we talk about the great recession of 2007 to 2009, we always talk about the housing bubble that crashed. And what happened is, when the housing bubble crashed, it led to only a small increase in aggregate demand. Remember, in the dynamic model, we're always shifting to the right. We're shifting everything to the right. However, this crash in the market led to only a small increase. Okay? That factored with our second bullet point here, the financial crisis. This also affected our aggregate demand as well. Because of the crash in the housing market, there was an unavailability of credit. There was a financial crisis that went with it and since there was no credit, there were no loans being made, firms were not making investments, there was no funds available. So aggregate demand shifted to the right even less, So the aggregate demand, what we're going to see is going to have a very small increase to the right. Now, what made matters worse was our third bullet point here, a supply shock coming from increasing oil prices. So international competition, mostly from China where there was a lot of production going on caused oil prices to skyrocket during this period as well. So these increasing oil prices caused a shift of our short-run aggregate supply to the left. If you recall when we talked about, supply shocks before, they're not going to affect our long run aggregate supply. Our long run aggregate supply is still going to increase in this model year over year because our potential GDP is still increasing based on, you know, technology increases in the labor force, whatever leads us to have a bigger potential GDP. However, the short run aggregate supply is going to be affected by these increased oil prices, which is more of a temporary situation, than our long run situation. Okay? So this supply shock shifted the short-run aggregate supply to the left and it was actually a big shift. So we're going to say SRAS went down a lot. Okay? So we're still going to see increases in aggregate demand, increases in long run aggregate supply. But we're going to see a big decrease in our short-run aggregate supply leading to an equilibrium, that was quite a mess. We had higher prices and low, production, low GDP as well. So let's go to our graph here and let's look at it here. So we're going to have our same graph with our price level and our real GDP, and then we'll have our initial situation. Let's say that we started in a long-run equilibrium, which isn't even totally true. But just to make it simple, we'll start in a long run equilibrium here, and this will be say in 2007. We were at this equilibrium with price level 1. Okay? And like I said okay. Let me label it first. We got our long run aggregate supply 1, short run aggregate supply 1, and aggregate demand 1. Okay? So that's everything, we've put on the graph so far. And we'll say this was in 2007. So I'll put 2007. And then all of these factors started to occur. There was the crash in the market, the financial crisis, the supply shock, and then we had our shifts for the 2008 curves. So we still see long run aggregate supply, our potential GDP increasing year over year. Okay? So this is our long run aggregate supply in 2008 still increased. However, nothing was able to keep up with it. Our aggregate demand only increased a little bit. We're only going to shift it to the right just a little bit here. So this is aggregate demand in 2008. It increased just a little bit from 2007 to 2008, but our short run aggregate supply decreased a lot. So what we're going to do is we're going to have a short-run equilibrium that's not in our long-run equilibrium. Let me draw this arrow somewhere else. Short run. So this short-run aggregate supply is shifting to the left, and it's shifting quite a bit. So we're going to shift it quite a bit way over here. So notice how much bigger that shift was in that short-run aggregate supply. So it's kind of going through this. Let me fix that a little bit. So this was our original long run aggregate supply, 2007. And finally, our short-run aggregate supply in 2008. Okay? So I know we've got a lot of curves there, but what we have is a short-run equilibrium that's not in the long run, right? In 2008, where is our short-run equilibrium? So our short-run equilibrium is going to be where our aggregate demand and our short-run aggregate supply cross. Can you find that point? I know we got a lot going on. So where's our aggregate demand for 2008? It's the red aggregate demand. And our short-run aggregate supply for 2008 is our short-run aggregate supply and those meet right here. So, notice what's happened from year over year. We had our original GDP in 2007 and our price level in 2007. And now, in 2008, the price level had skyrocketed, and our GDP had gone down. So it was just like doubly bad. Everything was bad here. Our GDP was down, and our price level had gone up, okay? So the recession occurred and we saw higher prices and lower GDP year over year, okay? And that's from this point right here. Okay? So that was how the 2007-2009 recession would look like on the dynamic AD-AS model. Now, I wouldn't expect you to have to draw this out, but it's still good to know when you have to study the dynamic model, How to graph the inflation and recession using that model. Cool? All right. Let's pause here and let's move on to the next video.

Here’s what students ask on this topic:

What causes inflation in the dynamic AD-AS model?

Inflation in the dynamic AD-AS model occurs when aggregate demand (AD) increases faster than short-run aggregate supply (SRAS). This imbalance leads to higher prices because the demand for goods and services exceeds the economy's ability to produce them. In the model, this is represented by a significant rightward shift in the AD curve, while the SRAS curve shifts only slightly to the right. The result is a new equilibrium with a higher price level. Understanding this dynamic helps explain why prices rise when spending outpaces production.

How did the 2007-2009 recession affect the dynamic AD-AS model?

The 2007-2009 recession impacted the dynamic AD-AS model through several key events. The housing bubble's collapse and the financial crisis led to only a slight increase in aggregate demand (AD). Concurrently, rising oil prices caused a significant leftward shift in short-run aggregate supply (SRAS). While long-run aggregate supply (LRAS) continued to increase, the combined effects resulted in higher prices and lower GDP. This scenario illustrates how adverse supply shocks and weak demand growth can lead to economic downturns, highlighting the importance of understanding these shifts in macroeconomic stability.

What is the difference between short-run and long-run aggregate supply in the dynamic AD-AS model?

In the dynamic AD-AS model, short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS) differ in their responsiveness to economic changes. SRAS can shift due to temporary factors like supply shocks (e.g., oil price increases), affecting production costs and output levels in the short term. In contrast, LRAS represents the economy's potential output, determined by factors like technology and labor force growth, and shifts gradually over time. While SRAS can fluctuate, LRAS typically increases steadily, reflecting long-term economic growth.

How do supply shocks affect the dynamic AD-AS model?

Supply shocks in the dynamic AD-AS model primarily affect short-run aggregate supply (SRAS). A negative supply shock, such as a sudden increase in oil prices, shifts the SRAS curve to the left, leading to higher production costs and reduced output. This results in higher prices and lower GDP in the short run. However, long-run aggregate supply (LRAS) remains unaffected by temporary shocks and continues to increase based on factors like technological advancements and labor force growth. Understanding supply shocks is crucial for analyzing short-term economic fluctuations and their impact on inflation and output.

What role did the financial crisis play in the 2007-2009 recession according to the dynamic AD-AS model?

The financial crisis during the 2007-2009 recession played a significant role in the dynamic AD-AS model by limiting the increase in aggregate demand (AD). The crisis led to an unavailability of credit, reducing loans and investments. Consequently, AD shifted only slightly to the right, reflecting weak demand growth. This, combined with a significant leftward shift in short-run aggregate supply (SRAS) due to rising oil prices, resulted in higher prices and lower GDP. The financial crisis thus exacerbated the recession by constraining economic activity and amplifying the negative effects of supply shocks.