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3.2

Aggregate Demand and Supply

The AD curve, components of AD, SRAS, LRAS, the Keynesian AS curve, and macroeconomic equilibrium.

You should be able to
  • Draw the AD curve and explain why it slopes downward
  • Identify the components of AD and their determinants
  • Draw and shift the SRAS curve; explain its determinants
  • Draw and explain the monetarist/new classical LRAS and Keynesian AS curves
  • Explain macroeconomic equilibrium in both models
  • Identify inflationary and deflationary gaps
Note

This section is pending teacher review.

Aggregate Demand (AD)

Aggregate demand is the total demand for all goods and services in the economy at different price levels, ceteris paribus.

Components of AD
AD = C + I + G + (X − M)

The AD curve slopes downward — as the price level rises, real GDP demanded falls.

Determinants of each component

ComponentKey determinants
C (consumption)Consumer confidence, interest rates, wealth, income taxes, household debt, expected future price level
I (investment)Interest rates, business confidence, technology, business taxes, corporate debt levels
G (government spending)Political and economic priorities (fiscal policy decision)
X − M (net exports)Trading partners' incomes, exchange rates, trade policies, relative inflation rates

Changes in any determinant shift the entire AD curve left or right.

Short-Run Aggregate Supply (SRAS)

The SRAS curve shows the total output all firms are willing to supply at different price levels in the short run (when some costs — especially wages — are fixed).

The SRAS curve slopes upward — higher price levels make production more profitable, incentivising firms to expand output.

Determinants of SRAS

  • Costs of factors of production — a rise in wages or raw material costs shifts SRAS left
  • Indirect taxes — higher taxes raise production costs, shifting SRAS left
  • A fall in production costs shifts SRAS right

Long-Run Aggregate Supply: Two Views

Monetarist/New Classical View (LRAS)

In the long run, the economy returns to its full employment level of output (potential output, YF). The LRAS curve is vertical at potential output — the price level does not affect long-run output.

At full employment, unemployment equals the natural rate of unemployment (structural + frictional + seasonal). Market forces automatically correct deviations from YF.

The LRAS shifts right due to: increases in quantity/quality of factors of production, technological improvements, efficiency gains, or institutional improvements.

Keynesian View (AS curve)

The Keynesian AS curve has three segments:

  • Horizontal (flat) section — at low levels of output, there is significant spare capacity; output can expand without raising the price level
  • Upward-sloping section — as the economy approaches capacity, bottlenecks appear and prices start to rise
  • Vertical section — at full capacity, output cannot increase further regardless of price level

Key Keynesian implication: economies can get stuck in a deflationary/recessionary gap (equilibrium below full employment) — the market does not automatically self-correct, requiring government intervention.

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs where AD = SRAS (short-run equilibrium) and potentially AD = SRAS = LRAS (long-run equilibrium at full employment).

Inflationary gap
When actual output exceeds potential output (Y > YF). Resources are over-employed; inflation pressures build. In the new classical model, rising wages shift SRAS left, restoring equilibrium at YF.
Deflationary/recessionary gap
When actual output is below potential output (Y < YF). Unemployment is above the natural rate. Keynesians argue this may persist; new classicals argue wages will eventually fall, restoring equilibrium.
Key points to remember
  • AD = C + I + G + (X − M); slopes downward
  • SRAS slopes upward; shifts with production costs and indirect taxes
  • LRAS (new classical) = vertical at YF; economy self-corrects
  • Keynesian AS = 3 segments; economies may get stuck below full employment
  • Inflationary gap: Y > YF; recessionary gap: Y < YF
  • LRAS shifts right = economic growth in production possibilities
Note

Practice questions are pending teacher review.

Practice Questions
1. Using an AD/AS diagram, show and explain the effect of a significant rise in consumer confidence on macroeconomic equilibrium.
Show answer
A rise in consumer confidence increases consumption (C), shifting the AD curve to the right (AD1 to AD2). In the new equilibrium, the price level is higher (inflationary pressure) and real GDP is higher. If the economy was in a recessionary gap, the rise in AD moves the economy closer to full employment. If the economy was already at full employment (LRAS), the rise in AD creates an inflationary gap — output is temporarily above YF, but rising wages will eventually shift SRAS left, restoring long-run equilibrium at a higher price level.
2. Compare the monetarist/new classical and Keynesian views of long-run aggregate supply. What are the policy implications of each view?
Show answer
The new classical LRAS is vertical — the economy always returns to full employment output (YF) in the long run through automatic adjustment (falling wages in a recession restore equilibrium). Policy implication: government intervention is unnecessary and may be harmful; let markets self-correct. The Keynesian AS curve is not vertical at all output levels — at low output, there is spare capacity and the economy may be trapped in a recessionary gap with no automatic correction. Policy implication: active government intervention (fiscal policy) is needed to shift AD and restore full employment.