Editing Macroeconomics (section)

====AD-AS model====

[[File:AS + AD graph.svg|thumb|A traditional AD–AS diagram showing a shift in AD, and the AS curve becoming inelastic beyond potential output]]

The [[AD–AS model]] is a common textbook model for explaining the macroeconomy.{{sfn|Healey|2002|p=12}} The original version of the model shows the price level and level of real output given the equilibrium in [[aggregate demand]] and [[aggregate supply]]. The aggregate demand curve's downward slope means that more output is demanded at lower price levels.{{sfn|Healey|2002|p=13}} The downward slope can be explained as the result of three effects: the [[Pigou effect|Pigou or real balance effect]], which states that as real prices fall, real wealth increases, resulting in higher consumer demand of goods; the [[Keynes effect|Keynes or interest rate effect]], which states that as prices fall, the demand for money decreases, causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers, leading to a decline in exports.{{sfn|Healey|2002|p=13}}

In many representations of the AD–AS model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of [[potential output]], which corresponds with [[full employment]].{{sfn|Healey|2002|p=12}} Since the economy cannot produce beyond the potential output, any AD expansion will lead to higher price levels instead of higher output.

In modern textbooks, the AD–AS model is often presented slightly differently, however, in a diagram showing not the price level, but the inflation rate along the vertical axis,<ref name=Romer/>{{rp|263}}<ref name=Mankiw/>{{rp|399–428}}<ref name=Sørensen/>{{rp|595}} making it easier to relate the diagram to real-world policy discussions.<ref name=Sørensen/>{{rp|vii}} In this framework, the AD curve is downward sloping because higher inflation will cause the central bank, which is assumed to follow an [[inflation target]], to raise the interest rate which will dampen economic activity, hence reducing output. The AS curve is upward sloping following a standard modern [[Phillips curve]] thought, in which a higher level of economic activity lowers unemployment, leading to higher wage growth and in turn higher inflation.<ref name=Romer/>{{rp|263}}