Aggregate demand and aggregate supply explained (AD/AS)

The aggregate demand and aggregate supply model (AD/AS) is the main tool of an intro macroeconomics course. It looks like the supply and demand diagram from the first weeks, which is both helpful and misleading: the shape is familiar, but the axes and the reasons behind each curve are different. Most exam mistakes on AD/AS come from carrying over single-market logic that doesn't apply.

What the model plots

• Horizontal axis: real GDP, the total output of the economy, adjusted for inflation.
• Vertical axis: the price level, an index such as the GDP deflator. Not the inflation rate. The inflation rate is the percent change in the price level, so a rise in the price level from 125.0 to 130.0 means inflation of 5 / 125 = 4.0%.

The model has three curves: aggregate demand (AD), short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).

Why AD slopes down

Aggregate demand is total spending on domestic goods and services at each price level: AD = C + I + G + (X - M), consumption plus investment plus government purchases plus net exports.

A single good's demand curve slopes down partly because buyers switch to substitutes. That can't explain AD, since there is no other economy to switch to. Instead, three effects do the work:

1. Wealth effect. A higher price level cuts the real value of savings, so households spend less.
2. Interest rate effect. A higher price level pushes up interest rates, which cuts business investment.
3. Foreign price effect. Domestic goods become dearer relative to foreign ones, so exports fall and imports rise.

If you have just finished the micro side, compare this with how a single good's demand responds to price in price elasticity of demand explained. Same downward slope, different causes.

Why SRAS slopes up and LRAS is vertical

Short-run aggregate supply is drawn holding input prices (above all wages) fixed. When the prices firms sell at rise but their input costs don't, profits rise and they produce more. So SRAS slopes up.

Its slope changes along the way. Far below potential GDP it is nearly flat, because idle workers and machines can be put to use without pushing up costs. Near potential GDP it is nearly vertical, because labor and capital are already fully employed.

Potential GDP is the output produced when labor and capital are fully employed and unemployment is at its natural rate. The long-run aggregate supply curve is a vertical line there: in the long run, output is set by resources and technology, not by the price level.

Finding the equilibrium: a worked example

Equilibrium is where AD and AS cross. This schedule is from the course cards (real GDP in dollars):

At a price level of 110, quantity demanded and quantity supplied are both 800, so equilibrium is a price level of 110 and real GDP of 800. Below 110, demand exceeds supply; above it, supply exceeds demand.

Shifts in aggregate demand

AD shifts right when consumption, investment, government spending or net exports rise at every price level, and left when any of them falls. Common causes:

• Consumer confidence moves C; business confidence moves I.
• Tax cuts raise C (or I); higher interest rates lower both.
• A recession in a trading partner cuts exports, shifting AD left.
• Rising household wealth, such as a stock market surge, raises C.

With AS unchanged, AD right means real GDP up and the price level up; AD left means both down.

Worked example: government spending rises. Demand becomes 130 higher at every price level. New AD at 120 is 750 + 130 = 880, which matches AS at 120. The new equilibrium is a price level of 120 and real GDP of 880. Real GDP rose by 880 - 800 = 80, not by the full 130, because part of the extra demand went into higher prices as the economy moved up the SRAS curve.

Worked example: confidence falls. Demand becomes 200 lower at every price level. New AD at 100 is 850 - 200 = 650, which matches AS at 100. The new equilibrium is a price level of 100 and real GDP of 650.

A change in the price level itself never shifts AD. It is a movement along the curve.

Shifts in aggregate supply

SRAS shifts right when productivity rises or input prices fall, and left when input prices rise or a supply shock hits (a frost, a war that removes workers, an oil price spike). Productivity growth is the most important long-run cause of rightward shifts, and it moves both SRAS and LRAS. A change in input prices moves only SRAS.

With AD unchanged, AS right means real GDP up and the price level down; AS left means real GDP down and the price level up.

Worked example: input prices rise. Supply becomes 130 lower at every price level. New AS at 120 is 880 - 130 = 750, which matches AD at 120. The price level rises from 110 to 120 while real GDP falls from 800 to 750, a change of -50. Output falls and prices rise at the same time: stagflation, the pattern of the 1970s oil shocks.

The four basic outcomes:

The three zones of the SRAS curve

Where the economy sits on SRAS decides what an AD shift does.

• Keynesian zone (the flat left part, far below potential): AD changes move output a lot and prices very little. This is Keynes' law, "demand creates its own supply", which fits the short run when resources sit idle, as in the Great Depression.
• Intermediate zone (the upward-sloping middle): AD right raises output and the price level together, so unemployment falls while inflationary pressure rises.
• Neoclassical zone (the steep part near potential): AD changes move mostly the price level. Output can only grow if AS shifts right. This is Say's law, "supply creates its own demand", a better approximation over decades than over months.

That is why the same tax cut can raise output with little inflation in a deep recession but mostly raise prices near full employment.

Output gaps and what the model can't show

A recession shows up as equilibrium real GDP well below potential. If potential GDP is $9,500 billion and equilibrium is $8,800 billion, output falls short by $700 billion, which is 700 / 9,500 = 7.4% of potential. Cyclical unemployment is high in that gap.

The model shows a one-time change in the price level. It cannot by itself explain inflation that persists year after year; that needs repeated AD stimulus near potential or built-in expectations of inflation, which the Phillips curve units take up.

Studying it

AD/AS is unit 11 of the course, and the map of Principles of Macroeconomics shows how the Keynesian, neoclassical, monetary and fiscal policy units all build on it. Practice by writing shift chains from memory (event, curve, direction, result) rather than redrawing the textbook graph; how to study for macroeconomics has a set to start from.

Two habits help most. Quiz yourself on mixed shift questions instead of rereading the chapter, since active recall beats passive review. And mix AD shocks and AS shocks in the same session, so each question makes you decide which curve moves first; interleaving vs blocking explains why that mixing pays off.

The supply and demand logic behind all this comes from the shared foundation units; how to study for microeconomics covers that side, and the Principles of Microeconomics map lists them. Fiscal policy shifts AD through laws Congress passes, which what's in American Government covers from the political side. More courses are collected in free college gen-ed course flashcards.

The full AD/AS unit, 6 chapters and 80 cards with every schedule problem recomputed by script, is free in Encodr's Principles of Macroeconomics course.