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Intermediate Macroeconomics Unit 8: Aggregate Demand and Aggregate Supply
The AD-AS model shows how demand and supply shocks move output and prices in the short run and how the economy returns to its natural level of output in the long run.
Covers: Deriving aggregate demand, Long-run and short-run aggregate supply, Sticky-price and imperfect-information models, Demand shocks and long-run adjustment, Supply shocks and stabilization, Okun's law
Study guide
Aggregate demand (AD) is the relationship between the price level and the quantity of output demanded. The simplest derivation uses the quantity equation: with M and V fixed, nominal spending PY = MV is fixed, so a higher P means lower Y. A fuller derivation uses IS-LM: a higher price level lowers real balances M/P, shifts LM up, raises the interest rate and lowers income. Either way, AD slopes down. Anything that raises spending at a given price level, such as more money, higher velocity, higher government purchases or lower taxes, shifts AD right.
Aggregate supply (AS) depends on the time horizon. In the long run, prices and wages are flexible, and output equals its natural level Ȳ, determined by capital, labor and technology: LRAS is vertical. In the short run, some prices are sticky or information is imperfect, so output can differ from Ȳ. Both standard models give SRAS: Y = Ȳ + α(P − Pᵉ). Output exceeds its natural level only when the price level is higher than people expected. In the sticky-price model, firms with preset prices sell more when demand rises; in Lucas's imperfect-information model, producers mistake general price increases for relative price increases.
Demand shocks move the economy along SRAS. A fall in AD lowers output and prices in the short run. Over time, as actual prices come in below expectations, people revise Pᵉ down, SRAS shifts down, and output returns to Ȳ at a lower price level. This self-correction can take years, which is one argument for stabilization policy. Long-run neutrality of money comes from this mechanism: a monetary expansion raises output only until expectations catch up. The slope of SRAS matters: when more firms have sticky prices, SRAS is flatter and demand shocks have larger output effects. Lucas showed that in countries with volatile demand, SRAS is steeper, because producers learn to read price changes as general inflation.
Supply shocks shift SRAS directly. An adverse shock, such as an oil price spike, raises costs, so prices rise and output falls: stagflation. Policymakers then face a hard choice. Holding AD constant keeps the price level from rising permanently but leaves a deep recession until prices fall back. Accommodating the shock by expanding AD keeps output at Ȳ but locks in a higher price level. Favorable supply shocks, such as the productivity boom of the late 1990s, allow higher output with lower prices.
Okun's law links output fluctuations to unemployment. A common version says that each percentage point of unemployment above the natural rate is associated with output about 2% below its natural level. In growth terms, %ΔY ≈ 3% − 2Δu: real GDP must grow about 3% a year just to keep unemployment steady, and faster growth lowers it. Okun's law lets us translate AD-AS output gaps into unemployment and connects this unit to the Phillips curve, which relates unemployment to inflation.
Key ideas
- AD slopes down because a higher price level lowers real money balances and spending.
- LRAS is vertical at natural output; SRAS slopes up because of sticky prices or imperfect information.
- Output exceeds its natural level only when prices exceed expectations: Y = Ȳ + α(P − Pᵉ).
- After a demand shock, changing expectations shift SRAS and return output to Ȳ.
- Adverse supply shocks cause stagflation and force a tradeoff for policymakers.
- Flatter SRAS curves make demand shocks matter more for output.
- Okun's law: about 2% of output per point of cyclical unemployment.
Formulas and rules
Common mistakes
- Shifting LRAS in response to demand shocks or money changes.
- Forgetting that expectations shift SRAS over time after a shock.
- Treating a velocity change as a supply shock instead of a demand shock.
- Using the level of unemployment, not its gap from the natural rate, in Okun's law.
- Assuming accommodating a supply shock keeps prices stable; it keeps output stable but raises prices.
Before the test, make sure you can
- Derive the AD curve from the quantity equation and from IS-LM.
- Explain why LRAS is vertical and why SRAS slopes up in the sticky-price and imperfect-information models.
- Solve linear AD and SRAS equations for short-run and long-run P and Y.
- Trace an economy's adjustment after demand shocks, with and without policy.
- Analyze supply shocks and the choice between accommodating and not accommodating.
- Use Okun's law to link unemployment, output gaps and real growth.
- Explain how the slope of SRAS depends on price stickiness and demand volatility.
Words to know
- Aggregate demand
- The relationship between the price level and the quantity of output demanded.
- Long-run aggregate supply
- A vertical line at natural output, independent of the price level.
- Short-run aggregate supply
- An upward-sloping relationship between the price level and output when some prices are sticky.
- Natural level of output
- The output produced when the economy is at the natural rate of unemployment.
- Expected price level (Pᵉ)
- The price level firms and workers expected when setting prices and wages.
- Sticky-price model
- A model in which some firms set prices in advance, making SRAS slope up.
- Imperfect-information model
- Lucas's model in which producers confuse general and relative price changes.
- Demand shock
- An event that shifts the AD curve, such as a change in money, velocity or spending.
- Supply shock
- An event that shifts the AS curve, such as an oil price change or a drought.
- Stagflation
- Falling output combined with rising prices.
- Accommodating policy
- Raising aggregate demand after an adverse supply shock to keep output at its natural level.
- Stabilization policy
- Policy aimed at reducing fluctuations in output and employment.
- Okun's law
- The negative relationship between unemployment and real GDP.
- Output gap
- The percentage difference between actual and natural output.
- Long-run neutrality
- In the long run, changes in money affect only prices, not output.
Sample practice questions
30 more questions like these, from level 1 to 5, are in the practice set.
Using the quantity equation with velocity and the money supply fixed, why does the aggregate demand curve slope downward?
- Firms supply less output when prices rise
- A higher price level lowers interest rates and raises investment
- A higher price level raises real wealth and spending
- With PY fixed at MV, a higher P means a lower Y
Show the answer and steps
Answer: D) With PY fixed at MV, a higher P means a lower Y
- The quantity equation MV = PY fixes nominal spending when M and V are fixed.
- Then P and Y must move in opposite directions: higher P, lower real balances M/P, less output demanded.
The long-run aggregate supply curve is vertical because:
- Long-run output depends on K, L and technology, not on P
- Prices are fixed in the long run
- The central bank fixes output at its natural level
- Aggregate demand cannot change in the long run
Show the answer and steps
Answer: A) Long-run output depends on K, L and technology, not on P
- In the long run, prices and wages are flexible and factors are fully employed.
- Output equals natural output Ȳ = F(K̄, L̄) at any price level.
New technology makes people want to hold less money for transactions, so velocity rises, with the money supply fixed. What happens?
- Nothing happens, because the money supply is unchanged
- Short-run AS shifts down: prices fall
- AD shifts left: output falls in the short run
- AD shifts right: Y rises at first, P rises in the long run
Show the answer and steps
Answer: D) AD shifts right: Y rises at first, P rises in the long run
- With M fixed, higher V raises nominal spending MV at every price level, shifting AD right.
- Prices are sticky in the short run, so Y rises; over time P rises and Y returns to Ȳ.