The Aggregate Demand & Aggregate Supply Model

The aggregate demand and aggregate supply (AD/AS) model is the central tool of macroeconomics. It puts the price level on the vertical axis and real GDP on the horizontal axis, and its equilibrium determines both at once — letting us explain growth, inflation and the business cycle on a single diagram.

The aggregate demand curve

Aggregate demand (AD) is total planned spending at each price level — the same C + I + G + (X − M) from the AE model, now plotted against the price level. It slopes downward: a lower price level raises real wealth, lowers interest rates and makes exports more competitive, so more is demanded. A change in the price level is a movement along AD; a change in any non-price determinant (confidence, interest rates, the exchange rate, government spending, overseas income) shifts the whole curve.

Short-run and long-run aggregate supply

The short-run aggregate supply (SRAS) curve slopes upward: with some input prices sticky in the short run, a higher price level makes production more profitable, so firms supply more. It shifts with input costs (wages, oil), productivity and supply shocks. The long-run aggregate supply (LRAS) curve is vertical at the economy's full productive capacity (potential output) — in the long run, output is set by resources and technology, not the price level. LRAS shifts only when productive capacity grows.

Equilibrium and a demand shock

Macroeconomic equilibrium is where AD meets AS. The diagram shows a rightward shift in AD (e.g. a surge in confidence or expansionary policy): both the price level and real output rise.

Explaining the business cycle

The model maps directly onto the cycle: an expansion is a rightward shift of AD (rising output, some inflation); a contraction is a leftward shift (falling output, easing inflation). A supply shock (e.g. an oil-price spike) shifts SRAS left, raising prices while cutting output — "stagflation". This is the engine of the next two lessons, where fiscal and monetary policy deliberately shift AD.

Shift the curves together, always reading both the price level and output at the new equilibrium.

Predict the equilibrium

For each event, state which curve shifts and which way, and the effect on the price level and real output:

• A collapse in consumer and business confidence. (AD left → P↓, Y↓)
• A large rise in labour productivity. (SRAS/LRAS right → P↓, Y↑)
• A big increase in government infrastructure spending. (AD right → P↑, Y↑)