The model
The aggregate demand (AD) curve shows the total quantity of real output that households, firms, government and foreigners want to buy at each overall price level. It slopes downward: a higher price level reduces the real value of wealth, raises interest rates and makes domestic goods dearer than foreign ones.
The aggregate supply (AS) curve shows the output firms will produce at each price level. In the short run it slopes upward, because some costs, such as wages in contracts, are slow to adjust. In the long run it is vertical at potential output, which depends on capital, labour and technology, not on the price level.
What shifts the curves
- AD shifters: anything that changes C, I, G or net exports at the same price level, such as consumer confidence, interest rates, government spending and taxes, or foreign income and exchange rates.
- AS shifters: input costs (oil, wages), productivity and technology, and supply shocks. Higher costs shift short-run AS left; higher productivity shifts it right.
Equilibrium and gaps
Equilibrium is where AD crosses short-run AS. If output is below potential, there is a recessionary gap, with high unemployment. If it is above potential, there is an inflationary gap, with unemployment below the natural rate and price pressure.
Worked example: a demand shock
A drop in business confidence cuts investment by 50.
- AD shifts left.
- In the short run, both the price level and real output fall, and unemployment rises: a recession.
- With high unemployment, wages and input prices eventually fall.
- Short-run AS shifts right and the price level falls further.
- Output returns to potential, but at a lower price level.
Whether the economy self-corrects quickly is disputed. Keynesians argue that wages are sticky, the adjustment can take years and demand policy can speed recovery. Classical economists argue that markets adjust faster and that policy mistakes are a bigger risk.
Supply shock
An oil price spike shifts short-run AS left. Output falls and prices rise together: stagflation. Policymakers face a dilemma, since boosting demand would reduce unemployment but worsen inflation.
Reading the diagram
Ask two questions. Which curve moved, and in which direction? Then read off the new price level and output. A leftward AD shift lowers both; a leftward AS shift lowers output and raises prices.