Aggregate Demand and Aggregate Supply
Aggregate Demand (AD) represents the total spending on goods and services in an economy at each price level. Aggregate Supply (AS) represents the total output firms are willing to produce at each price level. Together, the AD/AS model is the central framework in macroeconomics for analyzing GDP, unemployment, and inflation.
Key Takeaways
- Aggregate Demand (AD) slopes downward: as the price level falls, real wealth increases, interest rates fall, and exports become cheaper — all increasing total spending. AD = C + I + G + (X − M).
- Short-Run Aggregate Supply (SRAS) slopes upward: as the price level rises, firms produce more because input costs (especially wages) are sticky in the short run.
- Long-Run Aggregate Supply (LRAS) is vertical at full-employment GDP (potential output). In the long run, output depends on resources and technology, not the price level.
- Equilibrium occurs where AD intersects SRAS. If this is left of LRAS, there's a recessionary gap (unemployment). If right of LRAS, there's an inflationary gap.
The AD/AS Model Explained
The AD/AS model is to macroeconomics what supply and demand is to microeconomics — it's the framework you use to analyze everything. If you master this one model, you can handle most of the AP Macro exam.
Aggregate Demand represents total planned spending in the economy: consumption (C), investment (I), government spending (G), and net exports (X − M). The AD curve slopes downward for three reasons: the wealth effect (lower prices make people's savings worth more, so they spend more), the interest rate effect (lower prices reduce money demand, lowering interest rates, which boosts investment), and the exchange rate effect (lower prices make domestic goods cheaper for foreigners, boosting exports).
Short-Run Aggregate Supply slopes upward because of sticky wages and prices. If the overall price level rises but workers' wages are locked in by contracts, firms find it profitable to produce more — their revenue rises but their costs don't fully adjust yet. This is a short-run phenomenon.
Long-Run Aggregate Supply is vertical because in the long run, all prices and wages fully adjust. The economy produces at its potential output (full-employment GDP) regardless of the price level. The position of LRAS depends on the economy's productive capacity: labor force, capital stock, technology, and natural resources.
The key scenarios to understand: if AD shifts right (say, from government stimulus), output and the price level both increase in the short run. But if the economy is already at full employment, wages will eventually catch up to the higher prices, SRAS shifts left, and the economy returns to potential output at a higher price level. This is the self-correcting mechanism.
AD/AS on the AP Macro Exam
The AD/AS model is the single most important graph on the AP Macroeconomics exam. It appears in nearly every FRQ and a large portion of multiple-choice questions. You must be able to draw it accurately and quickly.
Always include three curves on your graph: AD, SRAS, and LRAS. Label the axes (Price Level on y-axis, Real GDP on x-axis), label all curves, and mark the equilibrium price level and output. If the question involves a gap, clearly show whether current output is left of LRAS (recessionary gap) or right of LRAS (inflationary gap).
Common FRQ prompts: "The economy is in a recessionary gap. Show this on an AD/AS graph. What fiscal/monetary policy would close the gap? Show the effect on your graph." Your answer should show AD shifting right until it intersects SRAS at the LRAS line.
For the self-correction mechanism: in a recessionary gap, high unemployment puts downward pressure on wages → SRAS shifts right → economy returns to full employment at a lower price level. In an inflationary gap, low unemployment puts upward pressure on wages → SRAS shifts left → economy returns to full employment at a higher price level. The AP exam often asks: "In the absence of policy, what happens in the long run?"
Common Mistakes Students Make
- Forgetting to draw LRAS. Many students only draw AD and SRAS. The LRAS curve is essential for showing the full-employment level of output and identifying gaps.
- Confusing short-run and long-run effects. A demand shock changes both output and price level in the short run. In the long run, output returns to potential (LRAS) and only the price level is different.
- Shifting LRAS when you should shift SRAS. LRAS only shifts when the economy's productive capacity changes (more workers, better technology, more capital). Input price changes (like oil shocks) shift SRAS, not LRAS.
Related Topics
Frequently Asked Questions
AD shifts when any component of spending changes for reasons other than the price level. Consumer confidence rising shifts AD right. Government increasing spending shifts AD right. The Fed lowering interest rates shifts AD right (more investment). A recession in a trading partner's economy shifts AD left (fewer exports). Tax cuts shift AD right (more consumer spending).
SRAS slopes upward because some input costs (especially wages) are sticky in the short run — firms produce more when prices rise because their costs haven't caught up yet. LRAS is vertical because in the long run, all wages and prices fully adjust, and the economy produces at its potential output regardless of the price level.
If the economy is in a recessionary gap (output below potential), high unemployment eventually drives wages down. Lower wages reduce firms' costs, shifting SRAS right until the economy returns to full employment. In an inflationary gap, the reverse happens: low unemployment drives wages up, shifting SRAS left. This long-run adjustment happens without any government or Fed intervention.