Aggregate demand and aggregate supply
The AD-AS model shows how shocks to spending and production move output and prices, and how the economy adjusts over time.
Aggregate demand revisited
The aggregate demand (AD) curve shows the total quantity of output demanded at each price level and slopes downward. It shifts when consumption, investment, government spending, or net exports change for reasons other than the price level, such as confidence, interest rates, or fiscal policy.
Short-run aggregate supply
The short-run aggregate supply (SRAS) curve slopes upward: when the price level rises while some costs, like wages set in contracts, are temporarily fixed, firms find it profitable to produce more. SRAS shifts with changes in input costs, such as wages and oil prices, and productivity.
Long-run aggregate supply
The long-run aggregate supply (LRAS) curve is vertical at potential output. In the long run, all prices and wages adjust, so output is determined by resources and technology, not by the price level. Economic growth shifts LRAS to the right.
Demand shocks
A negative demand shock, such as a collapse in confidence or a financial crisis, shifts AD left: output falls below potential, unemployment rises, and inflation falls. A positive demand shock, such as a boom in spending, raises output above potential and pushes up prices.
Supply shocks
A negative supply shock, such as a jump in oil prices or a pandemic disrupting production, shifts SRAS left: output falls and prices rise at the same time, producing stagflation. This poses a dilemma for policy: stimulating demand would worsen inflation, while tightening would deepen the slump.
Self-correction
In the AD-AS model, if output is below potential, unemployment eventually puts downward pressure on wages and costs, shifting SRAS right and returning output to potential. But this adjustment can be slow and painful, which is the case for using stabilisation policy, as Keynes argued: 'In the long run we are all dead.'
Schools of thought
Keynesian economists emphasise that demand shortfalls can cause prolonged recessions and that fiscal and monetary policy can help. Monetarists, led by Milton Friedman, emphasised money growth and rules. Real business cycle theorists argue fluctuations mainly reflect supply shocks such as technology changes. Modern mainstream models blend these views.
Worked example
In 2020, the pandemic hit both supply (factories and shops closed) and demand (people stopped spending on travel and restaurants). Output fell sharply. Large fiscal and monetary support then boosted demand while supply remained constrained, contributing to the inflation surge of 2021-2022.
Key takeaways
AD slopes down; SRAS slopes up because some costs are sticky; LRAS is vertical at potential output. Negative demand shocks lower output and inflation; negative supply shocks lower output while raising prices (stagflation). The economy can self-correct, but slowly, supporting stabilisation policy. Keynesian, monetarist, and real business cycle views differ on causes and remedies.
Flashcard
Total demand at each price level
Check your understanding
A sudden jump in global oil prices is most likely to cause: