Aggregate Demand, Aggregate Supply & Equilibrium

You’ll be able to

Explain the shape of the aggregate demand and short-run aggregate supply curves
Distinguish the short-run and long-run macroeconomic equilibria
Predict how shifts in AD or SRAS change output and the price level

Aggregate demand

The aggregate demand (AD) curve shows the total quantity of real output demanded at each price level, sloping downward. Its slope comes from three effects: the wealth effect (a lower price level raises the real value of money, so people buy more), the interest-rate effect (a lower price level reduces money demand and interest rates, boosting investment), and the net-export effect (a lower domestic price level makes exports cheaper abroad). AD is the sum of the spending components C + I + G + Xn, so anything that changes those components — consumer confidence, investment, government spending, or net exports — shifts the whole curve.

Short-run vs. long-run aggregate supply

The short-run aggregate supply (SRAS) curve slopes upward because, in the short run, some input prices (especially nominal wages) are "sticky" — a higher output price raises firms’ profits and encourages more production. The long-run aggregate supply (LRAS) curve is vertical at potential (full-employment) output, because in the long run all prices and wages adjust, and output is determined by real resources and technology, not the price level. SRAS shifts with input costs (wages, energy) and supply shocks; LRAS shifts only with changes in productive capacity — the same forces that shift the PPC.

The three equilibria

Short-run equilibrium sits where AD intersects SRAS. Compare that output to LRAS (potential) to name the situation. If equilibrium output is below potential, there is a recessionary gap (high unemployment); if above potential, an inflationary gap (overheating). Long-run equilibrium occurs where AD, SRAS, and LRAS all intersect — output equals potential with no output gap. The economy self-corrects toward long-run equilibrium as sticky wages eventually adjust, shifting SRAS, but this can be slow, which motivates active policy.

The components of aggregate demand

AD ≡ C + I + G + Xn

A rise in any component shifts AD right; a fall shifts AD left. This mirrors the GDP expenditure identity, now viewed as a demand relationship at each price level.

Worked example

An economy starts in long-run equilibrium. A sharp drop in consumer confidence reduces consumption spending. Trace the short-run effect on real GDP and the price level, and name the resulting output gap.

1.Consumption (C) is a component of AD, so a fall in C shifts the AD curve to the left.
2.Along the upward-sloping SRAS, a leftward AD shift moves equilibrium down the curve.
3.Real GDP falls and the price level falls (lower output and lower prices).
4.Because output is now below potential (LRAS), the economy has a recessionary gap with rising cyclical unemployment.

Answer: AD shifts left, so both real GDP and the price level fall, opening a recessionary gap with output below potential and rising unemployment. Left alone, sticky wages would eventually fall, shifting SRAS right to restore potential output — but slowly.

Checkpoint

The price of oil, a key input for many firms, rises sharply worldwide. Holding aggregate demand constant, what is the short-run effect on the economy?

Watch out

Keep AD and AS shifters straight. A change in a spending component (C, I, G, Xn) shifts AD. A change in input costs or productivity shifts AS. Confusing a demand shock with a supply shock leads to the wrong prediction for the price level.

Checkpoint

In the AD–AS model, the long-run aggregate supply (LRAS) curve is vertical because:

On the exam

Always draw the full AD–AS diagram with three curves (AD, SRAS, LRAS) and mark potential output. Free-response graders check that you correctly identify the gap relative to LRAS and shift the correct curve in the correct direction.

Answer the 2 checkpoints as you read.