Aggregate Demand & Supply

From Micro to Macro

U.S. real GDP fell from $15.6 trillion in Q4 2007 to $14.4 trillion in Q2 2009. Unemployment hit 10%. The housing sector collapsed, but the damage spread to banking, auto manufacturing, retail, and state budgets. One sector's failure dragged the whole economy down.

The AD/AS model exists to analyze exactly this kind of economy-wide event. Instead of one product or one industry, it handles total output and the overall price level.

The axes replace the micro variables from supply-and-demand diagrams. Price Level (PL) is the average of all prices economy-wide, measured by the CPI or GDP deflator. Not the price of any single good. Real GDP (Y) is total output, adjusted for inflation.

This framework is what economists use to diagnose recessions, explain inflation, and evaluate whether government policy is helping or making things worse.

Aggregate Demand (AD)

Consumers buy groceries. Businesses buy equipment. The government builds highways. Foreigners buy American exports. Sum it all: aggregate demand = C + I + G + (X - M).

The AD curve slopes downward for three reasons.

The wealth effect: a higher price level erodes the purchasing power of savings. People spend less. The interest rate effect: higher prices increase money demand, which pushes up interest rates. That chokes off business investment and big consumer purchases like cars and houses. The exchange rate effect: rising U.S. prices make American goods more expensive abroad, reducing exports and making imports look cheaper. Net exports decline.

What shifts AD? Changes in consumer confidence, government spending, tax policy, monetary policy, or foreign income. The Fed cutting rates to near zero during COVID was a massive rightward push on AD. A tax hike shifts AD left. When the European economy strengthened in 2017, U.S. exports rose and AD shifted right.

Short-Run Aggregate Supply (SRAS)

A factory owner in 2021. Prices for her products climb, but worker wages are locked in by contracts signed months ago. Every unit sold earns a wider margin, so she ramps up production. Scale that dynamic across millions of firms and you see why SRAS slopes upward.

"Short run" means the window where input prices remain sticky. Workers signed contracts last quarter. Suppliers quoted prices months ago. That lag between output prices and input costs gives the curve its upward slope.

Anything that changes production costs economy-wide shifts SRAS. The 1973 OPEC embargo sent energy costs surging, shifting SRAS left. A manufacturing technology breakthrough that lowers costs shifts SRAS right. Changes in wages, commodity prices, business taxes, regulations, and supply chain disruptions all work through this same channel.

LRAS and Full Employment

The Long-Run Aggregate Supply (LRAS) curve is a vertical line. Once all wages and prices have fully adjusted, output depends entirely on real resources: the workforce, the capital stock, and technology. Double every price and every wage overnight and nothing real changes. The same machines exist. The same people show up to work Monday.

That vertical line sits at potential GDP, the economy's maximum sustainable output. Where the economy sits relative to LRAS tells you a lot.

Left of LRAS: a recessionary gap. Factories sit idle, unemployment runs above the natural rate. The U.S. economy in 2009.

Right of LRAS: an inflationary gap. The economy overheats, overtime is everywhere, labor markets are tight. The late 1960s before inflation accelerated.

Self-correction works through wages. In a recessionary gap, high unemployment pushes wages down over time. Lower wages reduce production costs, shifting SRAS right until output returns to potential. In an inflationary gap, tight labor markets bid wages up, shifting SRAS left and cooling the economy back to LRAS. The mechanism is real. It can also take years.

Worked Example

MPC = 0.8. The government increases spending by $10 billion. How far does AD shift?

Spending multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5

Change in AD = 5 x $10B = $50 billion rightward shift.

The chain: the government pays $10B to construction firms. Workers earn that income and spend 80%, or $8B, at restaurants, stores, and landlords. Those recipients spend 80% of the $8B ($6.4B). The geometric series $10B + $8B + $6.4B + $5.12B + ... converges to $50B.

Now compare a $10B tax cut. Tax multiplier = -MPC / (1 - MPC) = -0.8 / 0.2 = -4. The same $10B only shifts AD right by $40B. Why the gap? Government spending injects the full $10B into the spending stream immediately. A tax cut lets households pocket $10B, but they save 20% before spending. Only $8B enters the first round. The spending multiplier exceeds the tax multiplier by exactly 1, regardless of the MPC. The AP exam tests this distinction constantly.