What you'll learn
Aggregate demand and aggregate supply do for the whole economy what demand and supply do for a single market: they determine a price level and a level of output, and they show what happens when something shifts. The apparatus looks familiar, and that familiarity is a trap — the curves slope as they do for entirely different reasons from their microeconomic counterparts, and an answer that recycles the micro explanations earns nothing.
Aggregate demand is total planned spending on domestic output at each price level: C + I + G + (X − M), the same components as the expenditure measure of GDP. It slopes downward, but not because of substitution towards other goods — there are no other goods when you are considering all output at once.
Aggregate supply is total planned output at each price level, and its shape differs between the short run and the long run. That difference is where the major disagreement in macroeconomics sits: whether an economy left alone returns to full employment on its own, and therefore whether demand management is necessary.
By the end you should be able to explain why each curve slopes as it does, identify what shifts them, analyse the effect of a shift on output and the price level, and use the model to explain inflationary and deflationary gaps.
Key terms and definitions
Aggregate demand (AD) — total planned spending on domestic output at each price level: C + I + G + (X − M).
Aggregate supply (AS) — total planned output at each price level.
Short-run aggregate supply (SRAS) — upward sloping, because money wages and some other costs are fixed in the short run.
Long-run aggregate supply (LRAS) — vertical at the full-employment level of output, since output then depends on resources and technology rather than on prices.
Full employment output — the output an economy produces when its resources are fully and efficiently used; also called potential output.
Deflationary (negative output) gap — equilibrium output below full employment, with unemployment and spare capacity.
Inflationary gap — demand exceeding full-employment output, so the excess raises prices rather than output.
Demand-pull inflation — inflation caused by aggregate demand rising beyond the economy's capacity.
Cost-push inflation — inflation caused by rising costs shifting aggregate supply leftward.
Stagflation — falling output alongside rising prices, the characteristic result of an adverse supply shock.
Core concepts
Why aggregate demand slopes downward
Three reasons, and none of them is the substitution effect that explains a single market's demand curve.
The wealth effect: a lower price level raises the real value of money held, so households feel wealthier and spend more.
The interest rate effect: a lower price level reduces the money needed for transactions, which lowers interest rates, which raises investment and interest-sensitive consumption.
The international trade effect: a lower domestic price level makes home-produced goods cheaper relative to foreign ones, so exports rise and imports fall, raising net exports.
Reproducing the micro income-and-substitution explanation here is a standing error, and examiners penalise it because it shows the model has been copied rather than understood.
What shifts aggregate demand
Anything changing a component of C + I + G + (X − M) at a given price level. Consumption shifts with income, wealth, confidence, interest rates and credit availability. Investment shifts with interest rates, business confidence, technology and expected demand. Government spending shifts with fiscal policy. Net exports shift with foreign income, the exchange rate and relative price levels.
A depreciation of the exchange rate raises net exports and shifts AD right — a point worth holding, since it connects this topic to the balance of payments.
Short-run aggregate supply
SRAS slopes upward because money wages and many input prices are fixed by contract in the short run. When the price level rises while wages are unchanged, real wages fall, profit margins widen, and firms expand output.
SRAS shifts with anything changing costs at a given price level: money wage rates, the price of imported inputs such as fuel, indirect taxes and subsidies, and productivity. A rise in world oil prices shifts SRAS left, raising the price level while reducing output — which is stagflation.
Long-run aggregate supply and the central disagreement
LRAS is usually drawn vertical at full-employment output. In the long run wages and prices adjust fully, so real output depends on the quantity and quality of resources and on technology — not on the price level.
This is where macroeconomics divides.
The classical view holds that the economy self-corrects. If output falls below full employment, unemployment pushes wages down, SRAS shifts right, and output returns to potential without intervention. Demand management is therefore unnecessary and, over time, merely inflationary.
The Keynesian view holds that wages are sticky downwards — workers and unions resist cuts — so the adjustment may be very slow or fail entirely. An economy can settle at an equilibrium below full employment and stay there. On this view, active demand management is needed to close the gap.
The practical question separating them is how fast wages adjust, which is empirical rather than theoretical. A strong evaluation says so rather than asserting one school.
Shifting LRAS
Only supply-side changes move potential output: more or better-educated labour, investment raising the capital stock, improved technology, better infrastructure, and institutional reform that raises efficiency.
That is the crucial distinction for policy. Demand management moves the economy along LRAS towards or away from potential; only supply-side measures move potential itself. An answer that treats a fiscal stimulus as raising long-run capacity has confused the two.
Reading the gaps
Where AD meets SRAS below full-employment output, there is a deflationary gap — unemployment and spare capacity, with room to raise output without much price pressure.
Where AD is high enough that the economy is at or beyond full employment, extra demand cannot raise real output. It raises the price level instead, producing demand-pull inflation — an inflationary gap.
The practical implication is that the effect of a demand stimulus depends entirely on where the economy currently sits. The same policy raises output in a slump and raises prices at full employment.
Worked examples
Example 1 — Computing aggregate demand (4 marks)
An economy records, in millions: consumption $600, investment $150, government spending $200, exports $180 and imports $230.
AD = C + I + G + (X − M) = $600 + $150 + $200 + (−$50) = $900 million.
The components are the same as the expenditure measure of GDP, which is why equilibrium output equals aggregate demand when the economy is in equilibrium. Net exports are negative $50 million, reducing AD below the $950 million of domestic spending.
Example 2 — A deflationary gap (5 marks)
Full-employment output is $1,000 million and equilibrium output is $900 million.
The economy has a deflationary gap of $100 million. Resources are unemployed and firms have spare capacity.
Because there is slack, an increase in aggregate demand raises real output with relatively little effect on the price level — the economy is operating on the flatter part of SRAS. Unemployment falls as output rises towards potential.
That is the case for a demand stimulus, and it holds only while the slack exists.
Example 3 — An inflationary gap (5 marks)
Aggregate demand now rises so far that planned spending exceeds $1,000 million at the current price level.
Real output cannot exceed $1,000 million, because the economy has no further resources to employ. The excess demand therefore raises the price level instead — demand-pull inflation.
The contrast with Example 2 is the point: an identical increase in aggregate demand raises output in one case and prices in the other. Which happens depends entirely on where the economy sits relative to full employment, and any answer recommending a stimulus should establish that first.
Example 4 — An adverse supply shock (5 marks)
World fuel prices rise sharply. The economy imports all its fuel.
Costs rise at every level of output, so SRAS shifts left. Equilibrium moves to a higher price level and lower real output — cost-push inflation combined with falling output, which is stagflation.
The policy difficulty is that the two problems call for opposite responses. Raising aggregate demand to restore output worsens the inflation; reducing demand to control inflation deepens the fall in output. Demand management cannot solve a supply-side problem, which is why supply-side measures — energy efficiency, alternative sources, productivity — are the appropriate response.
For a fuel-importing Caribbean economy this is not a textbook scenario but a recurring one.
Common mistakes and how to avoid them
Explaining the AD slope with income and substitution effects. Use the wealth, interest rate and international trade effects.
Confusing a movement along AD with a shift of it. A change in the price level moves along; anything else shifts.
Treating a fiscal stimulus as raising long-run capacity. Demand management moves the economy along LRAS; only supply-side change moves LRAS.
Saying a demand increase always raises output. At full employment it raises prices instead.
Trying to solve a supply shock with demand policy. The two problems require opposite responses.
Asserting that economies always self-correct — or never do. The dispute turns on how fast wages adjust, which is empirical.
Drawing LRAS as upward sloping. It is vertical at potential output, because prices do not determine real capacity in the long run.
How this links to your Internal Assessment
The AD–AS framework gives an Internal Assessment on a macroeconomic event a structure, because almost any shock can be classified as affecting demand or supply and the model then predicts the direction of both output and prices.
If you study a period when inflation and unemployment rose together, the framework identifies it immediately as a supply shock rather than a demand problem, and that classification is a finding rather than a description. Fuel price episodes and hurricane damage both fit.
Where you examine a government stimulus, establish first whether the economy had spare capacity at the time. A stimulus into an economy already at capacity raises prices, and evidence on unemployment or capacity utilisation is what settles which case applied.
Be careful in attributing causation. Output and prices move for many reasons at once, and a single episode rarely isolates one cause. Saying that the evidence is consistent with a supply shock, rather than that it proves one, is the honest and better-marked claim.
Exam technique for aggregate demand and supply
Describe shifts in words before reaching for a diagram: which curve moves, in which direction, and what happens to output and the price level. That sentence is the analysis, and the diagram illustrates it.
Give the three AD reasons by name — wealth, interest rate, international trade. They are worth a mark each and they are what distinguishes a macro answer from a recycled micro one.
For any shock, state both effects. A leftward SRAS shift raises prices and lowers output, and answers that mention only one lose half the marks available.
Command words follow the pattern. Explain why AD slopes downward wants the three effects. Distinguish between SRAS and LRAS wants the wage-adjustment reasoning and the vertical long-run shape. Analyse the effect of a rise in AD wants the answer conditioned on where the economy sits. Evaluate demand management wants the classical and Keynesian positions and a conclusion about the speed of adjustment.
Where the context is a fuel-importing Caribbean economy, the supply shock case is the most relevant application and examiners reward its use.
Quick revision summary
- AD = C + I + G + (X − M); the same components as the expenditure measure of GDP.
- AD slopes downward through the wealth, interest rate and international trade effects — never income and substitution.
- AD shifts with income, wealth, confidence, interest rates, fiscal policy, foreign income and the exchange rate.
- SRAS slopes upward because money wages are fixed in the short run, so a higher price level widens margins.
- SRAS shifts with wage rates, imported input prices, indirect taxes and productivity.
- LRAS is vertical at full-employment output, because real capacity does not depend on the price level.
- Classical view: wages adjust, the economy self-corrects, demand management is unnecessary.
- Keynesian view: wages are sticky downwards, so an economy can settle below full employment and stay there.
- The disagreement turns on how fast wages adjust — an empirical question.
- Deflationary gap: output below potential, so a demand rise raises output.
- Inflationary gap: at or beyond potential, so a demand rise raises prices — demand-pull inflation.
- An adverse supply shock gives stagflation: higher prices with lower output, which demand policy cannot fix.
- Only supply-side change shifts LRAS; demand management moves the economy along it.