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Applying the AD-AS model


Step one - identify the relevant variables

The focus of many exam questions is the requirement to undertake an analysis of the effects of a change in one macro-economic variable on another one. The list of possible variables, and their synonyms, is shown below:

Demand-side variables

  1. Household spending (C) (consumer spending)

  2. An injection (J) of new spending:

Investment (capital spending)

Government spending (public sector spending)

Export (overseas) spending

  1. A withdrawal (W) of spending:

Savings (savings ratio)

Taxation (direct taxes)

Imports (import spending)

  1. A monetary variable:

Interest rates (the cost of borrowing)

Exchange rates

The money supply

  1. A change in wealth:

House prices

Share prices

  1. Expectations:

Optimism (more confidence)

Pessimism (less confidence)

Supply-side variables

  1. A change in costs, such as:

Wages

Raw materials

Rents

  1. A change in labour productivity

Step two - identify the effect

Examiners can be very helpful, and tell you specifically what effect you have to write about, or they can be unhelpful and leave it up to you to interpret.

You need to know the likely effects of a change in an economic variable on:

  1. The price level (P)

  2. National income (output) (Y)

Both of these are shown directly on the AD/AS diagram.

  1. The level of employment

  2. The level of unemployment

  3. Public finances, (the balance between government spending and taxation)

  4. The Current Account balance (the balance between exports and imports)

The answer you get will depend upon:

  1. The ‘current state’ of the economy - is the economy near to full employment, or is there ‘slack’ in the economy.

  2. How big the initial change is.

  3. The time period being considered.

  4. How ‘elastic’ are the responses to the change being considered.

Step three - find the transmission mechanism

You need to fully explain both the:

  1. Transmission mechanism – how the initial change in a variable works its way towards the ‘final’ effect, and

  2. The ‘final’ effect itself.

You need explain the steps involved, from the initial change to the final effect, and to distinguish between shifts (caused by demand or supply-side shocks) and movements.

Step four - evaluate the effects

You can evaluate in different ways, including:

  1. Is the effect ‘good’ or ‘bad’?

  2. Will a ‘good’ effect also lead to a ‘bad’ effect, a ‘conflict’ or ‘trade-off?

  3. Is the effect ‘big or small’, significant or insignificant?

  4. How reliable are the statistics on which the analysis is based?

  5. What does the effect depend upon? The Ceteris Paribus rule can be used to discuss the other variables that are held constant.

  6. Are other factors likely to change, making the Ceteris Paribus rule unrealistic?

  7. Are other assumptions realistic? For example, will consumers respond elastically to the change in interest rates? If not, the effect of interest rate policy will be reduced.

  8. How quickly do the effects work? Are there time lags?