Aggregate Demand and Aggregate Supply

The aggregate demand–aggregate supply (AD-AS) model is the central framework of short-run macroeconomics. It extends the familiar supply-and-demand diagram to the entire economy, allowing us to analyze how output and the overall price level are determined and how they respond to shocks and policy. This chapter develops the two curves, explains what shifts them, and puts the model to work.

Aggregate Demand

Aggregate demand (AD) shows the total quantity of goods and services that all buyers — households, firms, government, and foreigners — are willing to purchase at each price level. The AD curve slopes downward, but for reasons different from those behind an individual demand curve. Three effects explain the slope:

• The wealth (real-balances) effect — A higher price level reduces the real value of money holdings, so people feel poorer and spend less.
• The interest-rate effect — A higher price level raises the demand for money, pushing up interest rates and discouraging investment and interest-sensitive spending.
• The foreign-purchases effect — A higher domestic price level makes home goods more expensive relative to foreign goods, reducing exports and increasing imports.

What Shifts Aggregate Demand

Anything that changes total spending at a given price level shifts the AD curve. The shifters correspond to its components — consumption, investment, government spending, and net exports. For example, rising consumer confidence, a tax cut, increased government spending, lower interest rates, or a weaker currency all shift AD to the right. Their effects are amplified by the multiplier.

Aggregate Supply

Aggregate supply (AS) shows the total output firms produce at each price level. Its shape depends on the time horizon.

• The short-run aggregate supply curve slopes upward: because some costs (especially wages) are slow to adjust, a higher price level raises profits and induces firms to produce more.
• The long-run aggregate supply curve is vertical at the economy's potential output (full-employment output): once all prices and wages have adjusted, output is determined by real factors — labor, capital, and technology — not by the price level.

What Shifts Aggregate Supply

Aggregate supply shifts when production costs or productive capacity change. A fall in input prices, a productivity improvement, or a favorable supply shock shifts AS to the right; a spike in energy prices or other adverse supply shock shifts it left.

Macroeconomic Equilibrium

The economy's short-run equilibrium occurs where AD and AS intersect, determining both the equilibrium price level and the equilibrium level of real output. This equilibrium need not coincide with full employment. If equilibrium output falls short of potential, the economy has a recessionary gap with cyclical unemployment; if it exceeds potential, an inflationary gap with upward pressure on prices.

Using the Model: Demand and Supply Shocks

The power of the model is in tracing the effects of shocks.

• A demand shock — say, a collapse in consumer confidence — shifts AD left, reducing both output and the price level and producing a recession. A positive demand shock raises output but also the price level (demand-pull inflation).
• A supply shock — say, a surge in oil prices — shifts short-run AS left, raising the price level while reducing output. This combination of stagnation and inflation, called stagflation, is especially difficult for policymakers because the tools that fight one problem tend to worsen the other.

This framework — AD and AS, equilibrium, and the response to shocks — is the lens through which we will evaluate fiscal and monetary policy in the chapters ahead.

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Next chapter: we put the model to use by examining fiscal policy — how government spending and taxes can be used to stabilize the economy.

Further Listening & Reading

• 🎥 The Aggregate Demand Curve (MRU) — building the AD curve.
• 🎥 The Short-Run Aggregate Supply Curve (MRU) — why short-run AS slopes upward.