4.3 Aggregate Demand and Aggregate Supply analysis
- Syllabus
- 9708–2026–2027
- Topic
- 4.3
- Level
- AS
Learning objectives
4.3.1Aggregate Demand• Definition of Aggregate Demand (AD)4.3.2AD components• Components of AD and their meanings: AD = C + I + G + (X - M)4.3.3AD determinants• Determinants of AD (detailed knowledge of the components of AD is not required)4.3.4AD curve shape• Shape of the AD curve (downward sloping)4.3.5AD shifts• Causes of a shift in the AD curve4.3.6Aggregate Supply• Definition of Aggregate Supply (AS)4.3.7AS determinants• Determinants of AS4.3.8SRAS and LRAS shape• Shape of the AS curve in the short run (SRAS, upward sloping line or sweeping curve) and the long4.3.9AS shifts• Causes of a shift in the AS curve in the short run (SRAS) and in the long run (LRAS)4.3.10AD/AS shifts vs movements• Distinction between a movement along and a shift in AD and AS4.3.11AD/AS equilibrium• Establishment of equilibrium in the AD/AS model and the determination of the level of real output, the price level and employment4.3.12AD/AS shift effects• Effects of shifts in the AD curve and the AS curve on the level of real output, the price level and employment
What aggregate demand measures
Aggregate demand (AD) is the total planned real expenditure on domestically produced goods and services at each average price level over a period, other determinants unchanged.
An AD curve places the average price level on the vertical axis and real output demanded on the horizontal axis. Each point is an economy-wide planned-spending outcome at a different price level, not a single money total detached from prices.
AD is not household demand for one product and is not found by horizontally adding individual demand curves. It includes planned spending by households, firms, government and overseas buyers on domestic output; the components are taught next.
Calculate AD from its four spending components
AD=C+I+G+(X-M)
| Component | Meaning | Important boundary |
|---|---|---|
| C | Household consumption of current goods and services | Excludes saving and asset purchases |
| I | Firms' spending on capital goods plus inventory investment | Not purchases of shares/bonds |
| G | Government purchases of current goods/services and capital | Excludes transfer payments |
| X | Exports: foreign spending on domestic output | Added |
| M | Imports: spending included elsewhere but produced abroad | Subtracted |
If C=500, I=120, G=180, X=90 and M=110, net exports are −20 and AD=500+120+180−20=780. Use values from the same period and units.
AD is not all spending by residents. Imports are removed because they are not domestic output, and benefits or pensions are transfers rather than direct government purchases of current output.
AD changes when its spending components or their determinants change
Consumption, investment, government spending and net exports are the components of AD. Income, interest rates, expectations, taxes, wealth, exchange rates and foreign income can change those components.
A determinant that increases planned spending shifts AD right; one that reduces it shifts AD left. Trace the component before drawing the curve.
A lower interest rate may raise consumption and investment, shifting AD right; a fall in foreign income can reduce exports and shift AD left.
A change in the price level is movement along AD, while a change in a component determinant shifts AD.
The downward-sloping AD curve links the price level to real output demanded
The AD curve shows the total real output demanded at different average price levels, holding other determinants constant. It slopes downward in the standard model.
A lower price level can increase real purchasing power, reduce interest rates and improve net exports, so planned real expenditure rises. These are mechanisms, not movements of the curve’s determinants.
A fall in the domestic price level can make exports more competitive and reduce the money needed for transactions, increasing real output demanded along AD.
AD is not the household demand curve for one good and its vertical axis is the price level, not one product’s price.
Trace causes of shifts in aggregate demand
AD shifts when planned spending changes at every price level. Use the chain: shock → AD component → spending direction → AD shifts right or left.
| Shock | Main component/channel | Typical AD direction |
|---|---|---|
| Lower interest rates or taxes; stronger confidence/wealth | C and/or I rise | Right |
| Higher government purchases or larger budget deficit from spending/tax changes | G and/or C rise | Right |
| Currency depreciation or stronger foreign income | X−M tends to rise | Right |
| Higher saving, interest rates or direct taxes; weaker confidence | C and/or I fall | Left |
| Currency appreciation, weaker foreign demand or greater import propensity | X−M tends to fall | Left |
State assumptions when they matter. A depreciation raises net exports only if export/import volumes respond sufficiently; a tax cut's effect depends on households' spending response; supply-side effects of the same policy are analysed separately.
A fall in the general price level is a movement down the existing AD curve, not a rightward shift. Always identify the non-price shock and component before moving the curve.
What aggregate supply measures
Aggregate supply (AS) is the total real output that firms across an economy are willing and able to produce at each average price level over a period, given production conditions and the time horizon.
An AS curve places the average price level on the vertical axis and real output supplied on the horizontal axis. The short-run and long-run versions differ because costs and productive capacity adjust differently over time.
AS is not one firm's supply curve or a simple sum that ignores economy-wide wages, inputs and capacity. Determinants, curve shapes and shifts are taught in the next episodes rather than folded into the definition.
Determinants of aggregate supply
AS depends on the cost and availability of producing economy-wide real output and on the economy's productive capacity.
| Determinant group | Mechanism | More AS when... |
|---|---|---|
| Wages, energy and raw-material prices | Change firms' unit costs | Unit costs fall |
| Indirect/business taxes and subsidies | Change effective production cost/return | Taxes fall or subsidies rise |
| Labour quantity and skills | Change usable workers and human capital | Participation, migration, health or skills improve |
| Capital stock and infrastructure | Change productive equipment and connectivity | Net investment/capacity rises |
| Technology and productivity | Change output possible per input | Efficiency improves |
| Natural resources and supply disruptions | Change accessible inputs | Availability/reliability improves |
| Institutions/regulation | Change incentives and ease of production | Effective rules support investment and allocation |
A determinant can affect current costs, sustainable capacity or both; do not assume every change shifts SRAS and LRAS equally or immediately. The horizon-specific shift test follows after the shape card.
Read SRAS and the two permitted LRAS shapes
Both SRAS and LRAS diagrams use the average price level vertically and real output horizontally. Their shapes express different assumptions about costs, spare capacity and the time available for adjustment.
| Curve/model | Permitted shape | Economic meaning |
|---|---|---|
| SRAS | Upward-sloping straight line or sweeping curve | Higher output is associated with a higher price level as bottlenecks and marginal costs rise in the short run |
| Vertical LRAS | Vertical at productive/full-employment capacity | Long-run real output is capacity-determined; price-level changes alone do not change sustainable output |
| Three-section LRAS | Highly elastic, then upward sloping, then vertical | With much spare capacity output can rise with little price pressure; pressure grows as resources tighten; at capacity extra AD raises prices rather than real output |
SRAS describes production while some input prices, contracts or capacity are fixed. LRAS describes sustainable output after adjustment. Moving along a curve uses existing capacity; expanding capacity requires an outward shift.
LRAS is not simply SRAS made steeper and is not downward sloping. State which LRAS convention is used before inferring how an AD change divides between real output and the price level.
Decide whether SRAS, LRAS or both shift
Classify an AS shift by mechanism and horizon: current unit-cost changes primarily shift SRAS; sustainable productive-capacity changes shift LRAS and often also affect SRAS as they take effect.
| Change | Typical curve effect | Direction and reason |
|---|---|---|
| Temporary wage, energy, import-input or indirect-tax rise | SRAS | Left/up: current unit costs rise |
| Opposite cost change or producer subsidy | SRAS | Right/down: current unit costs fall |
| More labour/capital, better skills, technology or infrastructure | LRAS; often SRAS over time | Right: sustainable capacity/productivity rises |
| Loss of working-age labour, capital or usable resources | LRAS; often SRAS | Left: sustainable capacity falls |
| Brief supply disruption with unchanged capacity | SRAS only | Left temporarily |
A sudden imported-oil price rise shifts SRAS left because firms' costs increase; it need not reduce long-run capacity. Net investment above depreciation expands capital stock, shifting LRAS right and potentially SRAS right as new capacity becomes usable.
Do not classify by whether the news sounds short- or long-term. Identify whether it changes present unit cost, sustainable capacity or both, and state the time horizon assumed.
Separate movements along AD/AS from shifts of the curves
A movement along AD or AS follows a change in the average price level, holding other determinants constant. A shift changes the whole curve because spending, costs or productive capacity change.
Identify the changed variable first, then decide whether the new equilibrium lies on the old curve or requires a new curve.
A higher price level moves the economy along AD; a tax change that alters consumption shifts AD. A wage shock shifts SRAS; a higher price level alone does not.
A new equilibrium point is not automatically a curve shift; compare the original and new determinants.
AD/AS equilibrium is the intersection that determines real output and the price level
In the AD/AS model, equilibrium occurs where planned aggregate expenditure equals firms’ aggregate supply at a given price level. The intersection determines real output and the average price level; employment is related through production.
If AD exceeds AS at the current price, firms see unintended stock falls and may increase output; if AS exceeds AD, inventories rise and output pressure weakens.
The intersection of AD and SRAS gives short-run output and price level; compare it with LRAS to judge whether output is above or below sustainable capacity.
Equilibrium output is not automatically full-employment output or a socially optimal price level.
Predict output, price and employment after AD/AS shifts
For a single shock, identify the shifted curve and direction, hold the other curve fixed, locate the new intersection, then read the changes in real output, price level and employment. Curve slope and spare capacity determine the size, not normally the direction, of a single-shift effect.
| Single shift under normal slopes | Real output | Price level | Employment |
|---|---|---|---|
| AD right | Rises | Rises | Rises |
| AD left | Falls | Falls | Falls |
| SRAS right | Rises | Falls | Rises |
| SRAS left | Falls | Rises | Falls |
| LRAS right with AD conditions stated | Sustainable capacity rises; actual output response depends on AD | Less inflation pressure / outcome depends on AD | Sustainable employment capacity may rise |
An AD increase near a highly elastic section raises output/employment with little price pressure; near vertical capacity it is mainly inflationary. An SRAS contraction creates stagflation: higher prices with lower output and employment.
With simultaneous shifts, combine only definite directions. AD right plus SRAS left definitely raises the price level, but real output/employment are ambiguous. AD left plus SRAS right definitely lowers the price level, but output/employment are ambiguous. Compare relative shift sizes for the uncertain variable.
Do not assume every AD rise causes only inflation or every supply contraction lowers prices. If both curves shift, do not report a definite result where their effects oppose one another.