# Aggregate Demand and Aggregate Supply

> Economics · CIE A-Level
> Source: https://www.owlsprep.com/study/cie-9708-u4-aggregate-demand-and-aggregate-supply/

This sub-topic introduces the core AD-AS model, the foundational framework for analyzing how price levels and national output are determined, and how macroeconomic shocks impact key economic indicators.

**Prerequisites:** [Circular flow of income](https://www.owlsprep.com/study/cie-9708-u4-circular-flow-income/); [National income accounting](https://www.owlsprep.com/study/cie-9708-u4-national-income-accounting/)

## Learning objectives

- Define aggregate demand (AD) and its core components
- Explain the shape of the AD, SRAS and LRAS curves
- Distinguish between short-run and long-run aggregate supply
- Use the AD-AS framework to analyze macroeconomic shocks
- Identify equilibrium price and output levels

## Aggregate Demand (AD): Components and Shape

**Aggregate Demand** — The total demand for all goods and services in an economy at a given price level in a given time period

*Notation:* AD

*Example:* AD combines demand from households, firms, the government and foreign buyers

AD is made of four core components, captured in the standard formula:

$$AD = C + I + G + (X - M)$$

- $C$ = Consumption: household spending on goods and services
- $I$ = Investment: firm spending on capital goods
- $G$ = Government spending on public goods and services
- $(X-M)$ = Net exports: export revenue minus import spending

The AD curve is downward sloping due to three key effects: the wealth effect, interest rate effect, and international trade effect.

**Worked example:** A fall in the average price level increases the real value of household wealth. Use the AD framework to explain the impact on total output demanded.

1. Recall the wealth effect: when the price level falls, the purchasing power of household assets (like savings) increases.
2. Higher real wealth encourages higher consumption spending, which increases the $C$ component of AD.
3. Higher $C$ leads to higher total output demanded at the lower price level. This confirms the downward slope of the AD curve: a fall in the price level causes a rise in real GDP demanded.

## Short-Run Aggregate Supply (SRAS)

**Short-Run Aggregate Supply** — Total output supplied when nominal wages and input prices are sticky (fixed) in the short run

*Notation:* SRAS

*Example:* Wages fixed by 1-year contracts or regulated fuel prices

The SRAS curve is upward sloping because when output prices rise, sticky input costs mean profit margins increase, giving firms an incentive to raise production. If output prices fall, margins shrink and firms cut output.

**Worked example:** Nominal wages are fixed by a 2-year contract. If the average price level rises by 5%, explain how this impacts aggregate output supplied in the short run.

1. Since nominal wages are fixed, the real wage (adjusted for inflation) paid by firms falls by approximately 5%.
2. Lower real wages reduce total production costs, increasing profit per unit of output.
3. Firms respond by increasing production to earn higher profits, so total aggregate output supplied rises.
4. This confirms the upward slope of the SRAS curve: higher price levels lead to higher output supplied in the short run.

## Long-Run Aggregate Supply (LRAS)

**Long-Run Aggregate Supply** — Total output supplied when all prices and wages are fully flexible, so the economy operates at full employment potential output

*Notation:* LRAS

In the long run, all input prices (including nominal wages) adjust fully to changes in the price level. Potential output depends only on the quantity and quality of factors of production (labor, capital, technology), not the price level, so LRAS is vertical at potential output.

**Worked example:** A permanent increase in the price level has no impact on long-run aggregate output. Explain why this holds.

1. In the long run, all nominal wages and input prices adjust fully to match the change in the average price level. A 10% increase in prices will eventually lead to a 10% increase in all input costs.
2. All prices rise by the same percentage, so relative prices (including real wages) remain unchanged.
3. Profit margins for firms return to their original level, so firms have no incentive to change their level of production.
4. Potential output is unchanged regardless of the price level, so LRAS is vertical at potential output.

## Macroeconomic Equilibrium and Shocks

Macroeconomic equilibrium occurs where the AD curve intersects the AS curve, determining the equilibrium price level and equilibrium real output. In the short run, equilibrium can occur below, at, or above potential output. In the long run, the economy adjusts back to potential output through shifts in the SRAS curve as wages and prices adjust.

Shifts in AD are caused by changes to any of its components (C, I, G, X-M). Shifts in SRAS are caused by temporary changes to input costs, while shifts in LRAS are caused by permanent changes to potential output.

**Worked example:** The government permanently increases infrastructure spending, ceteris paribus. Use the AD-AS model to show the short-run and long-run impact on price level and output.

1. Government spending ($G$) is a component of AD, so an increase in $G$ shifts the AD curve to the right.
2. The new intersection with the original SRAS curve occurs at higher real output and a higher average price level. If original equilibrium was at potential output, this creates an inflationary gap (output above potential).
3. In the long run, nominal wages adjust upward to reflect the higher price level, increasing production costs for firms and shifting the SRAS curve to the left.
4. The new long-run equilibrium returns output to potential output, but at an even higher price level than the short-run equilibrium.

## Common pitfalls

- **Wrong:** Shifting the AD curve when there is a change in the price level
  - Why it fails: AD plots the relationship between price level and output demanded, so changes in the price level cause movement along the curve, not shifts
  - Correct: Only shift AD when there is a change in non-price determinants (changes to C, I, G, or X-M)
- **Wrong:** Drawing an upward sloping LRAS curve
  - Why it fails: LRAS assumes all prices and wages are fully flexible, so output is determined by factors of production not the price level
  - Correct: Draw LRAS as a vertical line at the economy's potential output
- **Wrong:** Assuming an increase in AD permanently increases real output
  - Why it fails: If the economy is already at full employment, higher AD only raises prices in the long run, not output
  - Correct: Distinguish between short-run (higher output, higher prices) and long-run (output returns to potential, only prices rise) impacts of AD increases
- **Wrong:** Treating shifts in SRAS the same as shifts in LRAS
  - Why it fails: SRAS shifts come from temporary changes (e.g. one-off oil price changes), while LRAS shifts come from permanent changes to potential output
  - Correct: Only shift LRAS when there is a change to the quantity or quality of factors of production (e.g. new technology, higher labor force)

## Cheatsheet

| Concept | Curve Shape | What causes shifts? |
| --- | --- | --- |
| Aggregate Demand (AD) | Downward sloping | Changes to C, I, G, (X-M) |
| Short-run AS (SRAS) | Upward sloping | Changes to input prices, temporary supply shocks |
| Long-run AS (LRAS) | Vertical at Yp | Changes to quantity/quality of factors of production |
| Short-run Equilibrium | AD intersects SRAS | Determines short-run P and Y |
| Long-run Equilibrium | AD intersects SRAS at LRAS | Y = potential output |

## What's next

The AD-AS model is the foundation for all subsequent macroeconomic analysis in the CIE A-Level syllabus. You will use this framework to analyze the causes and consequences of core macroeconomic problems like inflation, cyclical unemployment, and recession, as well as to evaluate the impact of government fiscal and monetary policy. The distinction between short-run and long-run AD-AS adjustments is particularly critical for essay questions in Paper 4, where you are often required to compare short-run and long-run outcomes of policy changes. Mastery of AD-AS also allows you to analyze the impact of external shocks like global recessions or commodity price changes on open economies.

- [Inflation and deflation](https://www.owlsprep.com/study/cie-9708-u4-inflation-and-deflation/)
- [Unemployment](https://www.owlsprep.com/study/cie-9708-u4-unemployment/)
- [Economic Growth](https://www.owlsprep.com/study/cie-9708-u4-economic-growth/)

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