The AD-AS
Model
Master aggregate demand, aggregate supply, and how their intersection determines macroeconomic equilibrium: the price level and real GDP.
AP Macroeconomics
What Is the AD-AS Model?
The Aggregate Demand-Aggregate Supply model is the fundamental framework economists use to analyze fluctuations in real GDP and the overall price level of an economy. It brings together the total spending by all sectors and the total output produced by all firms.
Aggregate Demand
Total quantity of goods and services demanded at each price level: \( AD = C + I + G + NX \)
Aggregate Supply
Total quantity of goods and services firms are willing to produce at each price level.
The Aggregate Demand Curve
Three Reasons AD Slopes Down
1
Wealth Effect (Pigou): A lower price level raises the real value of money, making people feel wealthier and spend more on \( C \).
2
Interest-Rate Effect (Keynes): Lower prices reduce money demand, lowering interest rates and boosting \( I \) and \( C \).
3
Exchange-Rate Effect: Lower domestic prices make exports cheaper and imports costlier, raising \( NX \).
Short-Run vs Long-Run Aggregate Supply
SRAS
Upward-sloping: higher prices incentivize more output while input prices are sticky.
LRAS
Vertical at full-employment output \( Y_f \): in the long run, output depends on resources, not prices.
Macroeconomic Equilibrium
Recessionary vs Inflationary Gap
Recessionary Gap
Short-run equilibrium GDP is below \( Y_f \). Unemployment is above the natural rate. The economy is operating inside its PPC.
Inflationary Gap
Short-run equilibrium GDP is above \( Y_f \). Unemployment is below the natural rate. The economy is operating beyond sustainable capacity.
Shifters of Aggregate Demand
Changes in any component of \( AD = C + I + G + NX \) that are not caused by a change in the price level will shift the entire AD curve.
Consumer Spending \( C \)
Wealth changes, expectations, taxes, interest rates
Investment \( I \)
Interest rates, business expectations, technology
Gov't Spending \( G \)
Fiscal policy: spending increases or decreases
Net Exports \( NX \)
Exchange rates, foreign income, trade policy
Shifters of Aggregate Supply
1
Input prices: Changes in wages, energy costs, or raw materials shift SRAS.
2
Productivity: Technological advances shift both SRAS right and LRAS right.
3
Resource availability: Discovery of new resources or immigration shifts LRAS right.
4
Government regulation: Higher business taxes or regulations shift SRAS left (higher costs).
5
Inflationary expectations: If workers expect higher prices, they demand higher wages, shifting SRAS left.
How to Analyze a Shift
1
Identify the shock: Which determinant changed? Is it a demand-side or supply-side event?
2
Determine which curve shifts: AD, SRAS, or LRAS? Does it shift left (decrease) or right (increase)?
3
Find the new short-run equilibrium: The new intersection of AD and SRAS gives you the new PL and real GDP.
4
Assess the gap: Is real GDP above, below, or at \( Y_f \)? This tells you whether you have an inflationary or recessionary gap.
5
Long-run self-correction: SRAS will eventually shift to restore long-run equilibrium at \( Y_f \) through wage/price adjustments.
Example: Increase in \( G \)
Example: Negative Supply Shock
Long-Run Self-Correction
Policy Responses to Gaps
| Recessionary Gap | Inflationary Gap | |
|---|---|---|
| Problem | \( Y < Y_f \), high unemployment | \( Y > Y_f \), rising prices |
| Fiscal Policy | Increase \( G \), cut taxes | Decrease \( G \), raise taxes |
| Monetary Policy | Increase money supply, lower \( r \) | Decrease money supply, raise \( r \) |
| Effect on AD | AD shifts right | AD shifts left |
| Self-Correction | Wages fall, SRAS shifts right | Wages rise, SRAS shifts left |
Common Mistakes
✕ Confusing Movement vs Shift
A change in the price level causes movement along AD, not a shift. Only non-price-level factors shift AD.
✕ Mixing Up SRAS and LRAS Shifts
A change in input prices shifts SRAS only. Changes in resources, technology, or institutions shift LRAS (and often SRAS too).
✕ Forgetting Self-Correction
In the long run, the economy returns to \( Y_f \) through wage adjustments. Students often forget to show SRAS shifting back to LRAS.
Summary: Effects of Shifts
| Shift | Price Level | Real GDP | Unemployment |
|---|---|---|---|
| AD increases | Rises | Rises | Falls |
| AD decreases | Falls | Falls | Rises |
| SRAS increases | Falls | Rises | Falls |
| SRAS decreases | Rises | Falls | Rises |
| LRAS increases | Falls | Rises | Falls |
Question 1 of 5
If the economy is in a recessionary gap, which of the following will occur as the economy self-corrects in the long run?
In a recessionary gap, high unemployment pushes wages down over time. Lower wages reduce production costs, shifting SRAS right until the economy returns to \( Y_f \) at a lower price level.
Question 2 of 5
A sharp increase in oil prices would most likely cause which of the following short-run effects?
Higher oil prices increase production costs, shifting SRAS left. This leads to stagflation: the price level rises while real GDP falls.
Question 3 of 5
The aggregate demand curve slopes downward primarily because of which three effects?
The three reasons AD slopes downward are the wealth effect (Pigou), the interest-rate effect (Keynes), and the exchange-rate effect. These explain why a lower price level increases the quantity of real GDP demanded.
Question 4 of 5
If the government increases spending and the central bank simultaneously increases the money supply, what is the most likely short-run result?
Both increased \( G \) and an expanded money supply (lowering interest rates, boosting \( I \) and \( C \)) shift AD right. This raises both real GDP and the price level in the short run.
Question 5 of 5
The long-run aggregate supply (LRAS) curve is vertical because in the long run:
In the long run, all prices and wages are fully flexible. Output is determined by the economy's productive capacity: its resources, technology, and institutions. Changes in the price level do not affect long-run real GDP.