Aggregate demand (AD)
Aggregate means "all added together". Aggregate demand (AD) is the total spending on a country's goods and services at each price level.
AD = C + I + G + (X โ M): consumption by households, investment by firms, government spending, and exports minus imports.
Why AD slopes downward
- Wealth (real balance) effect: lower prices make savings buy more, so people spend more.
- Interest-rate effect: lower prices mean people need less money, interest rates fall, and borrowing for houses and machines rises.
- Exchange-rate (trade) effect: lower prices make exports cheaper for foreigners and imports relatively dearer, so net exports rise.
What shifts AD
Anything that changes C, I, G or net exports at the same price level: confidence, income tax, interest rates set by the central bank, government spending, foreign incomes, the exchange rate. A movement along AD happens only when the price level changes.
Short-run aggregate supply (SRAS)
Short-run aggregate supply (SRAS) is the total output firms are willing to produce at each price level when some costs (mainly wages and contracts) are fixed.
It slopes upward: if the price level rises but wages stay the same for a while (wages are "sticky"), each item earns more profit, so firms hire and produce more.
What shifts SRAS
- Costs of inputs: wages, oil, raw materials (higher costs โ SRAS shifts left).
- Productivity and technology (better โ right).
- Indirect taxes and subsidies on business.
- Supply shocks: drought, war, pandemics (usually left).
Long-run aggregate supply (LRAS) and two views
Long-run aggregate supply (LRAS) shows the output the economy can make when all prices and wages have fully adjusted and resources are fully employed. This output is called potential output or full-employment output (YF).
Classical (free-market) view
LRAS is vertical. In the long run the price level does not change real output; only real things do: the quantity and quality of labour and capital, technology, and institutions. Unemployment is at its natural rate.
Keynesian view
The LRAS curve is flat at low output (lots of idle workers and machines, so output can rise without prices rising), upward-sloping as the economy nears capacity, and vertical at full capacity. So an economy can stay stuck in a deep recession for a long time.
What shifts LRAS right
More or better-trained workers, more capital, new technology, better infrastructure, stable laws. This is long-run economic growth.
Equilibrium, shocks and output gaps
Short-run equilibrium is where AD crosses SRAS: it sets the price level (P) and real GDP (Y). Long-run equilibrium is when that point also lies on LRAS.
Four shocks
- AD rises (right): P up, Y up. If Y > YF โ inflationary (positive) output gap.
- AD falls (left): P down, Y down, unemployment rises โ recessionary (negative) output gap.
- SRAS falls (left, cost shock): P up and Y down โ stagflation (cost-push inflation).
- SRAS rises (right): P down and Y up (good news, e.g. cheaper energy).
Output gap % = (actual Y โ potential Y) รท potential Y ร 100.
Try it: before you move a slider, write down whether P and Y will go up or down. Then check in free play.
Long-run self-adjustment and automatic stabilisers
Self-adjustment (long run)
With an inflationary gap, jobs are plentiful, so workers win higher wages. Costs rise, SRAS shifts left until Y is back at YF, at a higher price level. With a recessionary gap, unemployment pushes wages down (slowly), SRAS shifts right, and Y returns to YF at a lower price level. Classical economists trust this process; Keynesians say wages fall very slowly, so government action is needed.
Automatic stabilisers
These are parts of the budget that change by themselves with the economy, without new laws:
- Progressive income tax: in a boom people pay more tax, which cools spending; in a slump they pay less.
- Unemployment benefits and welfare: rise in a slump, keeping spending up.
They make AD swing less. Discretionary policy, by contrast, is a deliberate new decision (a stimulus package, a rate cut).
Key formulas and definitions
- AD = C + I + G + (X โ M)
- Short-run equilibrium: AD = SRAS
- Long-run equilibrium: AD = SRAS = LRAS (Y = Y_F)
- Output gap % = (Y โ Y_F) รท Y_F ร 100
- AD right โ Pโ, Yโ ; AD left โ Pโ, Yโ
- SRAS left โ Pโ, Yโ (stagflation) ; SRAS right โ Pโ, Yโ
- Inflationary gap: Y > Y_F ; recessionary gap: Y < Y_F
Worked examples
1. A country has C = 600, I = 150, G = 200, X = 120, M = 170 (all in billion $). Find AD.
AD = C + I + G + (X โ M) = 600 + 150 + 200 + (120 โ 170) = 950 โ 50 = 900 billion $.
2. Potential output is 2,000 billion and actual output is 1,900 billion. Find the output gap and its type.
Gap = (1,900 โ 2,000) รท 2,000 ร 100 = โ5%. Negative โ recessionary gap.
3. AD: P = 12 โ Y and SRAS: P = 2 + Y. Find the equilibrium Y and P.
Set equal: 12 โ Y = 2 + Y โ 10 = 2Y โ Y = 5. Then P = 12 โ 5 = 7. (This is step 2 in the 3D.)
4. Spending rises so AD becomes P = 14 โ Y (SRAS still P = 2 + Y, Y_F = 5). Find the new equilibrium and the gap.
14 โ Y = 2 + Y โ Y = 6, P = 8. Gap = (6 โ 5) รท 5 ร 100 = +20% โ inflationary gap. Both P and Y rose. (Step 3.)
5. Starting from Example 4, wages rise until SRAS is P = 4 + Y. Find the long-run result.
14 โ Y = 4 + Y โ Y = 5, P = 9. Output is back at Y_F = 5 but the price level rose from 7 to 9. This is long-run self-adjustment. (Step 4.)
6. An oil shock moves SRAS from P = 2 + Y to P = 4 + Y while AD stays P = 12 โ Y. What happens?
12 โ Y = 4 + Y โ Y = 4, P = 8. Price level up (7 โ 8), output down (5 โ 4): stagflation, gap = โ20%.
Common mistakes
- Thinking AD slopes down for the same reason as a single demand curve. AD uses the wealth, interest-rate and exchange-rate effects, not "substitution to other goods".
- Shifting AD when only the price level changes. A price-level change is a movement along the curves.
- Drawing LRAS sloping upward in the classical model. Classical LRAS is vertical at potential output.
- Calling every price rise "demand-pull". If SRAS shifted left (costs up), output falls too: that is cost-push / stagflation.