Aggregate Demand and Aggregate Supply analysis

Economics AS · The Macroeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Aggregate demand (AD) is the total planned spending on an economy's goods and services at each price level. The AD curve slopes downwards. Aggregate supply (AS) is the total output that firms plan to produce at each price level. SRAS slopes upwards. LRAS is vertical in the classical view. In the Keynesian view it has three sections: highly elastic when there is spare capacity, then upward sloping, then vertical at full capacity.

A change in the price level causes a movement along a curve. Any other cause shifts a curve. Where AD meets AS gives the equilibrium price level and real output. Employment moves in the same direction as real output.

Rules to remember

AD = C + I + G + (X − M): consumption, investment, government spending, net exports
AD shifts right when C, I, G or (X − M) rises, e.g. lower interest rates, lower income tax, higher confidence
SRAS shifts left when costs of production rise, e.g. higher wages, dearer raw materials or oil
LRAS shifts right when the quantity or quality of factors of production rises, e.g. better technology, education, more capital
AD shifts right: real output and the price level rise (on vertical LRAS only the price level rises)
SRAS shifts left: real output falls and the price level rises
SRAS shifts right: real output rises and the price level falls

Common mistake

Students shift the AD curve when the price level changes. A change in the price level is a movement along AD or AS; only non-price causes shift the curves.

Worked example

An economy is on the upward-sloping part of its SRAS curve. The central bank raises interest rates and nothing else changes. What happens to real output, the price level and employment?

Higher interest rates make borrowing dearer and saving more rewarding, so consumption and investment fall.
C and I are components of AD, so the AD curve shifts to the left.
The economy moves down along the SRAS curve to a new equilibrium.

Answer: Real output falls, the price level falls and employment falls.

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