Lesson 3.5: Aggregate Supply & Demand

Lesson Overview

In the real world, economies face shocks: consumers change spending, businesses change investment, governments change budgets, and unexpected events change production costs. The question is: how do these forces affect the economy’s total output and the overall price level?

The Aggregate Demand–Aggregate Supply (AD-AS) model is a simple framework that helps us reason about these changes. It explains why recessions often come with rising unemployment, why inflation can rise during booms, and why supply shocks can create the painful combination of higher prices and lower output.

In this lesson, you will learn what aggregate demand and aggregate supply mean, how the economy reaches macroeconomic equilibrium, and how policy and shocks can shift the equilibrium in the short run and long run.

Learning Objectives

• Define aggregate demand and explain why it slopes downward.
• Define short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).
• Describe macroeconomic equilibrium in the AD-AS model.
• Explain how demand shocks and supply shocks change output and the price level.
• Identify recessionary gaps and inflationary gaps using potential GDP.
• Explain, at a high level, how fiscal and monetary policy can shift aggregate demand.
• Explain the short-run vs. long-run adjustment process when the economy is away from potential GDP.

Key Ideas: Price Level and Real GDP

The AD-AS model uses two big-picture variables:

• Price level — a broad measure of average prices across the economy (not the price of one item).
• Real GDP — inflation-adjusted output (how much the economy actually produces).

On an AD-AS graph, the vertical axis is the price level and the horizontal axis is real GDP.

Aggregate Demand (AD)

Aggregate demand is the total spending on domestically produced final goods and services at each possible price level. It connects to the GDP spending identity: GDP = C + I + G + (X − M).

Why AD Slopes Downward

In macroeconomics, the “price level” affects spending through several channels:

• Wealth effect: when the price level rises, the purchasing power of money balances falls, so people feel poorer and may spend less.
• Interest rate effect: higher price levels can increase the demand for money; interest rates may rise, discouraging borrowing and spending.
• Net exports effect: when domestic prices rise relative to foreign prices, exports tend to fall and imports rise, reducing net exports.

Together, these effects create a negative relationship between the price level and the quantity of real GDP demanded.

What Shifts Aggregate Demand?

A shift in AD means people want to buy more (or less) real output at every price level. Common shifters include:

Consumption (C) Shifters

• Consumer confidence and expectations
• Taxes (after-tax income)
• Household wealth (stocks, housing, savings)

Investment (I) Shifters

• Interest rates and credit conditions
• Business expectations and profitability outlook
• Technology and productivity opportunities

Government Purchases (G) Shifters

• Changes in government spending on goods and services

Net Exports (X − M) Shifters

• Foreign income growth (affects demand for exports)
• Exchange rates (affect exports and imports)
• Trade policy changes

When these rise overall, AD shifts right. When these fall overall, AD shifts left.

Aggregate Supply (AS): Short Run vs. Long Run

Aggregate supply describes how much real output firms are willing to produce at different price levels. The key difference is time: the short run behaves differently than the long run.

Short-Run Aggregate Supply (SRAS)

SRAS shows the relationship between the price level and real GDP produced in the short run. It typically slopes upward: when the price level rises (while many input costs are slow to adjust), firms can become more profitable and increase production.

Why SRAS Slopes Upward (Simple Intuition)

• Some wages and input prices adjust slowly (“sticky” costs).
• Higher output prices can temporarily raise profits.
• Firms respond by producing more and hiring more.

Long-Run Aggregate Supply (LRAS)

LRAS is vertical at potential GDP. In the long run, the economy’s output depends on resources and productivity (labor, capital, technology, institutions), not the price level.

The LRAS line represents what the economy can produce when resources are used at sustainable “full employment” levels.

Macroeconomic Equilibrium

The economy is in macroeconomic equilibrium where AD intersects SRAS. This determines:

• The equilibrium price level, and
• The equilibrium level of real GDP (output).

The key question is whether equilibrium real GDP equals potential GDP (the LRAS level).

Recessionary and Inflationary Gaps

Compare equilibrium output to potential GDP:

Recessionary Gap

If equilibrium real GDP is below potential GDP, the economy has a recessionary gap. Unemployment tends to be higher than normal, and output is below what the economy could sustainably produce.

Inflationary Gap

If equilibrium real GDP is above potential GDP, the economy has an inflationary gap. Resources are being used beyond sustainable levels, and inflation pressure tends to rise.

Demand Shocks in the AD-AS Model

A demand shock shifts the AD curve. In the short run, AD shifts change both output and the price level.

AD Shifts Right (Boom / Expansion Pressure)

• Output rises (real GDP increases)
• Price level rises (inflation pressure)
• Unemployment tends to fall

AD Shifts Left (Recession Pressure)

• Output falls
• Price level falls or inflation slows
• Unemployment tends to rise

This helps explain why recessions often come with weak output and rising unemployment.

Supply Shocks in the AD-AS Model

A supply shock shifts SRAS. Supply shocks are especially important because they can move output and prices in opposite directions.

Negative Supply Shock (SRAS Shifts Left)

Costs rise or production becomes harder.

• Output falls
• Price level rises
• Unemployment rises

This combination—higher prices and lower output—is often called stagflation.

Positive Supply Shock (SRAS Shifts Right)

Costs fall or productivity rises.

• Output rises
• Price level falls or inflation slows
• Unemployment falls

Short-Run vs. Long-Run Adjustment

In the short run, prices and wages do not fully adjust. Over time, adjustments in wages, expectations, and input costs can shift SRAS.

If the Economy Is Below Potential GDP

Weak demand leads to lower pressure on wages and some costs over time. SRAS may shift right as costs ease, moving the economy back toward potential GDP.

If the Economy Is Above Potential GDP

Tight labor markets and strong demand put upward pressure on wages and costs. SRAS may shift left as costs rise, moving the economy back toward potential GDP.

In this view, the long run tends to pull the economy back toward LRAS (potential GDP), though the process can be slow and painful.

Policy in the AD-AS Framework (High-Level)

Policymakers often try to stabilize output and inflation by influencing aggregate demand.

Fiscal Policy

Fiscal policy involves government spending and taxation. In general:

• Higher government spending or lower taxes tends to shift AD right.
• Lower government spending or higher taxes tends to shift AD left.

Monetary Policy

Monetary policy (often through interest rate changes and financial conditions) influences borrowing and spending:

• Easier monetary conditions tend to shift AD right.
• Tighter monetary conditions tend to shift AD left.

The AD-AS model helps explain why stabilization policy can involve tradeoffs, especially when the economy faces supply shocks.

Practice: Predict the Direction of Change

1. Consumer confidence rises sharply. What happens to AD? What happens to output and the price level in the short run?
2. Energy prices spike and transportation costs rise. What happens to SRAS? What happens to output and the price level?
3. The government increases spending on infrastructure. What happens to AD?
4. Productivity improves due to new technology. What happens to SRAS and/or LRAS?
5. Explain why LRAS is vertical while SRAS is upward sloping.

Reflection Prompt

Think about an economic event you’ve lived through (a period of rapid inflation, a recession, or a boom in your industry).

• Was it mostly a demand shock, a supply shock, or both?
• What happened to jobs and wages?
• What happened to prices?
• What policy responses did you observe, and what tradeoffs did they involve?

What’s Next?

In Lesson 3.6: Economic Growth, we’ll shift from the short run to the long run by studying what increases potential GDP over time—capital accumulation, productivity, technology, and the institutions that support growth.