Aggregate Demand and Aggregate Supply

Economics· 6 min read

1. Aggregate Demand (AD): Components and Shape★★☆☆☆⏱ 20 min

📘 Definition

Aggregate Demand

AD

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

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.

2. Short-Run Aggregate Supply (SRAS)★★☆☆☆⏱ 20 min

📘 Definition

Short-Run Aggregate Supply

SRAS

Total output supplied when nominal wages and input prices are sticky (fixed) in the short run

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.

3. Long-Run Aggregate Supply (LRAS)★★★☆☆⏱ 25 min

📘 Definition

Long-Run Aggregate Supply

LRAS

Total output supplied when all prices and wages are fully flexible, so the economy operates at full employment potential output

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.

4. Macroeconomic Equilibrium and Shocks★★★☆☆⏱ 30 min

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.

5. Common Pitfalls

Wrong move:

Shifting the AD curve when there is a change in the price level

Why:

AD plots the relationship between price level and output demanded, so changes in the price level cause movement along the curve, not shifts

Correct move:

Only shift AD when there is a change in non-price determinants (changes to C, I, G, or X-M)

Wrong move:

Drawing an upward sloping LRAS curve

Why:

LRAS assumes all prices and wages are fully flexible, so output is determined by factors of production not the price level

Correct move:

Draw LRAS as a vertical line at the economy's potential output

Wrong move:

Assuming an increase in AD permanently increases real output

Why:

If the economy is already at full employment, higher AD only raises prices in the long run, not output

Correct move:

Distinguish between short-run (higher output, higher prices) and long-run (output returns to potential, only prices rise) impacts of AD increases

Wrong move:

Treating shifts in SRAS the same as shifts in LRAS

Why:

SRAS shifts come from temporary changes (e.g. one-off oil price changes), while LRAS shifts come from permanent changes to potential output

Correct move:

Only shift LRAS when there is a change to the quantity or quality of factors of production (e.g. new technology, higher labor force)

6. Quick Reference 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

When this came up on past exams

AI-estimated based on syllabus patterns — cross-check with official past papers for accuracy. Use only as revision-focus signals.

2022 · 4
AD-AS analysis of demand-side policy
2021 · 4
Compare SRAS and LRAS shapes
2023 · 2
Impact of supply shock on equilibrium

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.