The Journal of Private Enterprise 31(4), 2016, 97–105

A Dynamic AD–AS Analysis of the UK Economy,

2002–2010

Anthony J. Evans*
ESCP Europe Business School
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Abstract
This educational note helps instructors to utilize the Cowen/Tabarrok
dynamic AD–AS model. I use it to interpret some major shocks and policy
responses that hit the UK economy from 2002 through 2010 and I describe
how to incorporate the model into a classroom setting.
__________________________________________________________

JEL Codes: A22, B53, E52, E62, E32

Keywords: AD–AS model, macroeconomics, monetary policy,
undergraduate teaching

Introduction
In their Modern Principles of Macroeconomics textbook, Tyler Cowen and
Alex Tabarrok introduce a dynamic version of the aggregate
demand–aggregate supply (AD–AS) model.1 It is a simple framework
to make sense of economic shocks and policy responses. Its main
difference from the traditional AD–AS model is that instead of
showing the price level and real GDP on the two axes, the dynamic
version shows inflation (on the Y axis) and real GDP growth (on the
X axis), making the analysis much more accessible to students for
two reasons. First, in a world of sustained inflation, it can be
confusing to model declines in aggregate demand as leading to a fall
in the price level. Second, inflation and growth are the main
economic indicators discussed in the news—after all, inflation targets
tend to be 2 percent, and recessions are defined as two quarters of
negative GDP growth. Therefore, the dynamic model allows students
to instantly draw upon their existing knowledge of the main

* I appreciate helpful comments from Eli Dourado and an anonymous referee on

previous versions of this paper. The usual disclaimer applies.
1 Readers who are unfamiliar with the dynamic AD–AS model should start with the

thorough exposition provided in Cowen and Tabarrok (2009). There is also an

unaffiliated video introduction on YouTube titled “An Introduction to the
Dynamic AD–AS Model.”
98 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105

economic indicators.2 This article will discuss how it can be used to

illustrate movements in the UK economy from 2002 through 2010.3

I. The UK Case Study (2002–2010)

The following text can be used directly with students, who are
required to identify which curve(s) will shift and draw the new
diagram. The solution (i.e., the graph) can be revealed alongside the
actual data (see appendix).

Instruction 1: Your task is to depict the following shocks to the UK

economy using the dynamic AD–AS model. The starting point is the
first quarter of 2002. The “Great Moderation” is occurring, where
productivity gains and the emergence of China and India as trading
partners have created a relatively high potential growth rate. Real
GDP growth is 2.2 percent, which you can treat as being equal to the
Solow rate.4 Inflation is in line with expectations, and indeed inflation
expectations remain stable throughout the entire analysis.5 The
money supply is growing at 7 percent, and V is falling by 2.4 percent.

2 Wren-Lewis (2013) has argued that since the Phillips curve shows inflation, we
should use that and simply ignore the AD–AS model. However, as Sumner (2009)
has argued, using the Phillips curve would place too much emphasis on demand
shocks and would neglect supply shocks. Mueller (2014) attempts to inject some
Austrian consideration to macroeconomic configurations by presenting a “goods
side” and “money side” model. Like the dynamic AD–AS model, it draws upon the
Solow model and is also based on the equation of exchange. However, it explains
things in terms of levels rather than growth rates. A dynamic version of the AD–
AS model may be the best of all worlds.
3 The figures are taken from “Second Estimate of GDP: Quarter 4 (Oct to Dec)

2015,” Office for National Statistics, February 25, 2016. The appendix shows NGDP
data for the United Kingdom from Q1 2002 through Q4 2010. The GDP deflator
is being used as the measure of inflation so that it is compatible with the real GDP
growth measure, and thus sums to our measure of NGDP. Unfortunately, using
the GDP deflator means that we lose the ability to talk in terms of changes to CPI.
For the periods chosen, there is not a dramatic difference between the two
measures of inflation, and the CPI figure is included in the appendix. Also,
Christensen (2012) has pointed out that the European Central Bank often conflates
the GDP deflator and CPI.
4 Indeed, the long-term average real GDP growth rate, calculated from Q1 1957 to

Q4 2001, is 2.345 percent. We can treat this rate as being approximately equal to
the Solow rate.
5 This seems like a dramatic over simplification, but two-year-ahead inflation

expectations remained reasonably close to 2 percent from 2006 through 2010 (see
“Do Inflation Expectations Currently Pose a Risk to Inflation?” Bank of England
Quarterly Bulletin 2015 Q2). There are no real estimates of GDP deflator
expectations, so we assume that they remain constant at 2.4 percent.
 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105 99

Draw the dynamic AD–AS model, identify the inflation rate, and
label the starting position point A. (Figure 1 shows what the graph
should look like.)

Figure 1. Q1 2002

Instruction 2: In August 2005, the Bank of England’s Monetary

Policy Committee (MPC) cut interest rates from 4.75 percent to 4.5
percent, and this cut preceded an increase in the growth rate of the
broad money supply. Despite some economists flagging the dangers
of double-digit growth in broad money at the time,6 because
inflationary pressures weren’t evident in CPI figures, the MPC turned
a blind eye to it. This period also saw an increase in the growth rate
of government spending. In 2002, government spending accounted
for around 36 percent of GDP, but by 2007 it was 39 percent.7 By

6 Congdon et al. (2006) argued that “although the current welcome decline in oil
and gas prices may depress headline inflation in the next few months, this should
not disguise underlying concerns about domestic inflation.” A similar story
occurred in Europe. Eurozone M3 was growing at around 6.5 percent from 2000
until 2006. It then began to escalate quickly, rising to almost 10 percent in 2008 (see
Christensen 2012).
7 This increase in G could suggest that AD was too high, and as Cowen and

Tabarrok (2009) point out, this is a temporary phenomenon and therefore at some
future point we should expect negative shifts in AD. Note that excessive growth in
government spending also implies negative shifts in the Solow curve, because
100 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105

Q4 2007, the economy was growing at 3.1 percent and inflation had
risen to 2.8 percent.8 Draw an updated graph and label the new
situation point B. (Figure 2 shows what the graph should look like.)

Figure 2. Q4 2007

Instruction 3: The actual growth rate of real GDP is now beyond

the Solow rate; in other words, growth is being driven by excessive
AD rather than high potential GDP. This suggests that the growth
rate is unsustainable, but there is also evidence that the Solow rate
may be falling. According to Congdon (2007), UK output was 1
percent to 1.5 percent above trend growth at the beginning of 2008
due to factors such as declining North Sea oil production, the
squeeze on financial services (the largest source of UK value
creation), and planning restrictions. However, this negative
productivity shock is small (assume Y* falls to 1.8 percent) in
comparison to the massive demand shocks that are occurring. These
include a stock market crash (which constitutes a reduction in wealth
and a reduction in consumption spending); government attempts to
spend lots of money and reassure people (which generates regime
uncertainty that leads to a massive fall in private investment); and
damage to financial intermediation caused by the collapse of some of
the largest banks. AD drops to –4 percent, with real GDP reaching

government spending can crowd out private expenditure and private sector
investment, which will reduce total factor productivity.
8 The rise in inflation immediately prior to a crash is evidence of the Ricardo effect

(see Miller 2009).

 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105 101

–5.9 percent in Q1 2009. Show the impact of these simultaneous

shocks, and label the new situation point C.9 (Figure 3 shows what
the graph should look like.)

Figure 3. Q1 2009

Instruction 4: In March 2009, the MPC launched quantitative easing

(QE) in an effort to boost AD, and despite being dampened by a
simultaneous increase in capital requirements (see Bridges and
Thomas 2011) and also offset by fiscal austerity, by Q4 2010, AD
rose by 8.5 percentage points.10 If this increase in AD coincides with
the underlying Solow curve, show the UK economy as of Q4 2010
and label it point D. (Figure 4 shows what the graph should look
like.)

9 It is only through a combination of a negative AD and a negative Solow shock

that we would expect such a large decline in real GDP growth but such a moderate
fall in inflation. During 2008, the MPC were reluctant to cut interest rates because
CPI was high. The diagram above demonstrates the problem with inflation
targeting. Because of a negative Solow shock, the concurrent AD shock wasn’t
deflationary. But it was highly damaging to the real economy.
10 Despite the rhetoric, the evidence suggests that little austerity actually took place

(see Evans 2012). Also, the UK policy uncertainty index fell during this period,
suggesting a rise in confidence.
102 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105

Figure 4. Q4 2010

Point D isn’t an equilibrium, because inflation is above

expectations. But since further elaborations would make things even
more complicated, it seems a reasonable place to stop. Events in the
Eurozone could be added to, which would constitute a negative AD
shock. In addition, the previous austerity was front-loaded with tax
increases that are likely to damage the economy’s underlying
potential. Therefore, we could factor that in as a negative real shock.
We might also emphasize a point made by Salter (2012): that regime
uncertainty is best expressed as a short-term decline in AD, but over
time, this also reduces the long-run growth potential.11 There are
plenty of ways to extend the analysis and bring it up to date.
However, the four-step process from A to B to C to D already covers
a number of different shocks and is testing enough to be an
appropriate application for an undergraduate class.

II. Conclusion
Instructors can debrief by providing a critique of various policy
decisions. Indeed, we identify three claims about the point at which
monetary policy errors were made. The first is 2002, by orchestrating
an NGDP growth rate that was suboptimally high. The second is
August 2005, with the decision to cut interest rates. The third is
September 2008, with the decision to allow NGDP growth

11 It’s debatable whether it’s best to show this as a future shock to Solow or as an

immediate one.
 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105 103

expectations to collapse. The reason the MPC allowed NGDP to

contract in 2008–09 was because they were committed to a 2 percent
inflation target. This discussion allows us to link the discussion with
one about monetary policy rules, and the dynamic AD–AS model is
especially helpful in distinguishing between money growth rules
(targeting M), inflation targets (P), or NGDP growth targets (P+Y).
The dynamic AD–AS model is a highly useful framework for
understanding the economy. Cowen and Tabarrok’s use of the Solow
curve follows nicely from the concepts introduced in growth theory.
The AD curve bridges the quantity theory with the Keynesian cross,
and the SRAS curve emphasizes the signal extraction problem.
Indeed, a downside of the traditional AD–AS model is distinguishing
between long-run and short-run supply shocks. The dynamic model
overcomes this downside because the only shock that will shift the
SRAS is a change in inflation expectations. All real shocks (regardless
of how “permanent” they are) will shift the Solow curve. Students
often find this concept easier to grasp.
The case study provided is an attempt to combine some of the
most important shocks to the UK economy, and the models’
predictions fit the stylized facts.
References

Bridges, Jonathan, and Ryland Thomas. 2011. “The Impact of QE on the UK

Economy—Some Supportive Monetarist Arithmetic.” Bank of England
Working Paper.
Christensen, Lars. 2012. “Failed Monetary Policy—(Another) One Graph
Version.” Market Monetarist.
Congdon, Tim. 2007. “Evidence to the Treasury Select Committee.”
Congdon, Tim, et al. 2006. “Higher Rate Rises May Be Needed to Contain
Inflation.” Financial Times, September 27.
Cowen, Tyler, and Alex Tabarrok. 2009. Modern Principles of Macroeconomics. United
States: Worth.
Evans, Anthony J. 2012. “In Search of Austerity: An Analysis of the British
Situation.” Arlington, VA: Mercatus Center.
Miller, Robert C. B. 2009. “The Austrians and the Crisis.” Economic Affairs, 29(3):
27–34.
Mueller, Antony P. 2014. “Beyond Keynes and the Classics: Outline of the Goods
Side/Money Side Model of the Business Cycle and Macroeconomic
Configuration.” Working Paper.
Salter, Alexander W. 2012. “Thoughts on Policy Uncertainty.” Market Monetarist,
November 12.
Sumner, Scott. 2009. “The Tabarrok/Cowen AS/AD Model.” Money Illusion,
December 1.
Wren-Lewis, Simon. 2013. “Mystified on AS/AD.” Mainly Macro, June 5.
104 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105

Appendix: NGDP
GDP
CPI RGDP NGDP
Deflator
D7G7 IHYU IHYR IHYO
2002 Q1 1.5 2.4 2.2 4.6
2002 Q2 0.9 1.8 2.2 4.0
2002 Q3 1.0 2.9 2.5 5.5
2002 Q4 1.5 3.0 3.1 6.2
2003 Q1 1.5 2.8 3.4 6.3
2003 Q2 1.3 2.7 3.5 6.3
2003 Q3 1.4 2.5 3.3 5.9
2003 Q4 1.3 2.9 3.2 6.2
2004 Q1 1.3 2.3 3.1 5.5
2004 Q2 1.4 3.1 2.7 5.9
2004 Q3 1.3 3.2 2.2 5.4
2004 Q4 1.4 3.1 1.9 5.1
2005 Q1 1.7 3.1 1.9 5.1
2005 Q2 2.0 3.3 2.5 5.9
2005 Q3 2.4 2.5 3.3 5.9
2005 Q4 2.1 2.7 4.3 7.1
2006 Q1 1.9 3.2 4.0 7.3
2006 Q2 2.3 2.4 3.1 5.6
2006 Q3 2.4 3.3 2.2 5.7
2006 Q4 2.7 3.1 1.4 4.5
2007 Q1 2.9 3.0 2.0 5.1
2007 Q2 2.6 2.8 2.3 5.1
2007 Q3 1.8 2.9 2.9 5.9
2007 Q4 2.1 2.8 3.1 6.0
2008 Q1 2.4 3.0 2.4 5.5
2008 Q2 3.4 2.9 1.2 4.2
2008 Q3 4.8 2.8 –1.2 1.5
2008 Q4 3.9 2.8 –4.2 –1.5
2009 Q1 3.0 2.1 –5.9 –4.0
2009 Q2 2.1 1.8 –5.6 –3.9
2009 Q3 1.5 2.0 –3.8 –1.9
2009 Q4 2.1 2.2 –1.3 0.9
2010 Q1 3.3 3.4 0.7 4.1
2010 Q2 3.5 3.8 1.7 5.6
2010 Q3 3.1 2.5 2.0 4.6
2010 Q4 3.4 2.7 1.8 4.5
2011 Q1 4.1 3.0 2.1 5.2
2011 Q2 4.4 1.5 1.7 3.2
2011 Q3 4.7 2.1 2.0 4.1
2011 Q4 4.6 1.9 2.1 4.0
 A. Evans / The Journal of Private Enterprise 31(4), 2016, 97–105 105

GDP
CPI RGDP NGDP
Deflator
D7G7 IHYU IHYR IHYO
2012 Q1 3.5 0.8 1.5 2.3
2012 Q2 2.8 1.6 1.0 2.6
2012 Q3 2.4 2.1 1.2 3.4
2012 Q4 2.7 2.0 1.0 3.0
2013 Q1 2.8 1.6 1.4 3.1
2013 Q2 2.7 2.2 2.2 4.5
2013 Q3 2.7 2.3 2.1 4.5
2013 Q4 2.1 1.8 2.8 4.7
2014 Q1 1.7 2.1 2.8 4.9
2014 Q2 1.7 2.3 3.0 5.4
2014 Q3 1.5 1.8 2.8 4.6
2014 Q4 0.9 1.2 2.8 4.1
2015 Q1 0.1 0.8 2.6 3.4
2015 Q2 0.0 0.5 2.4 2.8
2015 Q3 0.0 0.0 2.1 2.1
2015 Q4 0.1 0.0 1.9 1.9
Source: “Second Estimate of GDP: Quarter 4 (Oct. to Dec.) 2015,” Office for
National Statistics, February 25, 2016. Figures subject to revision.