The booms and the busts of the business cycle – Introduction to AD – AS models

The business cycle is an economic phenomenon which describes changes in the level of economic output compared to a long run average. A simple set of data illustrating the business cycle is shown below. The level of Real GDP in most countries increased by a positive rate each year from 2000 – 2008, before the Global Financial Crisis caused the most significant recession and then recovery in recent history.

In Macroeconomics we can model changes in the level of economic activity using the Aggregate Demand and Aggregate Supply model. This theoretical idea is shown on the following diagram, which explains the link between the business cycle and the level of aggregate demand and aggregate supply in the economy.

When the actual GDP line is above the potential GDP line the economy is said to have a positive output gap as at the peak point. Aggregate Demand exceeds the potential capacity thus shortages occur and prices rise (inflation) also called an inflationary gap. Factors of production such as labour, land and capital are fixed in the short run, and wages can not change. Therefore the inflationary gap will remain in the short run.

 

When the actual GDP line is below the potential GDP line the economy has a negative output gap as in a recession. At this point there is spare capacity, higher then average unemployment leading to less inflationary pressures in the aggregate economy.  Also called a recessionary gap. We can relate this concept back to the Real GDP data, which explains a dramatic fall in the level of economic activity in 2009.

Each of these two simple scenarios is caused by changes in Aggregate Demand. As we studies last week, changes in Aggregate Demand can be caused by a variety of factors which influence each component

Components of Aggregate Demand (AD)

C – Consumer Spending

I – Investment

G – Government Spending

(X-M) – Net Export Receipts

The two following videos highlight changes to the level of Aggregate Demand and the resulting inflationary and recessionary gaps. The first video explains how the Chinese government is boosting aggregate demand by increasing government spending and investment. It is a likely response to boost economic activity, and to reduce unemployment.

The second video is a quick look at the UK government budget. A government budget explains the countries spending and taxation decisions for the coming year. The UK was forced to reduce government spending due to the countries very high levels of public debt. The UK has been forced to borrow money to pay for current spending, which increases the nations debt to the rest of the world.

Discussion Questions and Activities:

  1. Explain any changes to Aggregate Demand that would result in an inflationary gap occurring?
  2. When a country is experiencing an inflationary gap, what happens to price levels and the level of unemployment?
  3. Video 1: What are the impacts on level of economic activity due to the government investment?
  4. Video 2: The UK government is planning to increase VAT tax rates and decrease spending on national defence. Explain the likely effect of the level of economic activity using the AD/AS model.
  5. In your notes draw an AS/AD model to explain the impacts of the events shown in each video. Be careful to fully label any changes.
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2 thoughts on “The booms and the busts of the business cycle – Introduction to AD – AS models

  1. Louis Odendaal says:

    I just did this lesson with my IB Econ SL class today and it went down really well. The students found it clear and to the point. Thanks s much for sharing and creating these fantastic resources.

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