The interaction of aggregate demand and supply

What you'll learn

• How aggregate demand and aggregate supply are used to model the whole economy.
• The key assumptions behind AD/AS diagrams.
• How macroeconomic equilibrium is found and interpreted.
• How shifts in AD and AS affect growth, inflation, unemployment and the current account.

Start with the big picture

The aggregate demand and aggregate supply model is a way of analysing the whole macroeconomy. Instead of looking at one market, such as coffee or labour, it looks at the relationship between the general price level and real GDP.

Real GDP means the value of national output adjusted for inflation. In simple terms, it measures how much the economy is producing.

Aggregate demand: planned spending

Aggregate demand is made up of four components:

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

where C is consumption, I is investment, G is government spending, X is exports and M is imports. Exports minus imports are called net exports.

AD slopes downwards because, as the price level rises, UK goods become less price competitive, the real value of money balances falls, and interest rates may rise if demand for money increases. These effects reduce planned spending.

Aggregate supply: productive capacity and costs

SRAS slopes upwards because higher output usually increases pressure on firms’ costs. For example, firms may need to pay overtime, hire less suitable workers, or compete for scarce raw materials. If prices rise faster than costs, firms have an incentive to produce more.

LRAS shows what the economy can produce sustainably. It depends on supply-side factors such as the size and skills of the labour force, capital stock, technology, infrastructure, and institutional quality.

Assumptions behind the AD/AS model

The AD/AS model is useful, but it rests on simplifying assumptions.

First, it assumes ceteris paribus, meaning “all other things being equal”. When you shift AD, you assume SRAS has not also changed unless the question gives you a reason.

Second, it assumes the economy can be represented by one general price level and one measure of real output. This hides regional, sectoral and distributional differences.

Third, the standard short-run model assumes some prices and wages are sticky. This is why an increase in AD can raise real GDP in the short run rather than only raising prices.

Fourth, the long-run model assumes productive potential is determined by real factors such as labour, capital and productivity. This is close to a neo-classical view. A more Keynesian view places greater emphasis on spare capacity and the possibility that weak demand can persist for a long time.

Macroeconomic equilibrium

Macroeconomic equilibrium occurs where aggregate demand equals aggregate supply. In the short run, this is where AD intersects SRAS.

The diagram below shows AD, SRAS and LRAS. Equilibrium is at E, where AD and SRAS meet. Because Y1 is below Y*, the economy has a negative output gap.

An output gap is the difference between actual real GDP and potential real GDP.

$$Output\; gap\; (\%)=\frac{actual\; real\; GDP-potential\; real\; GDP}{potential\; real\; GDP}\times 100$$

Shifts in AD and AS

A movement along a curve is caused by a change in the price level. A shift of a curve is caused by a non-price factor.

AD shifts right if consumption, investment, government spending or net exports increase. For example, lower interest rates may increase borrowing and spending, while higher overseas growth may increase UK exports.

SRAS shifts right if production costs fall or productivity rises. For example, cheaper energy, lower indirect taxes, or improved supply chains can increase SRAS. SRAS shifts left if costs rise, such as during an oil price shock or major supply-chain disruption.

LRAS shifts right when productive potential increases. This might come from education, infrastructure, business investment, migration, innovation or institutional reform.

The next diagram compares a demand-side expansion with an adverse supply shock.

Effects on macroeconomic indicators

The key macroeconomic indicators are economic growth, inflation, unemployment and the current account of the balance of payments. The current account records flows such as trade in goods and services, plus income flows.

A leftward shift in SRAS is especially difficult because it can cause stagflation: rising inflation and falling real output at the same time. The UK’s post-pandemic energy and supply-chain pressures are useful AO2 context here, as they increased firms’ costs and contributed to the cost-of-living squeeze.

Evaluation: what determines the final impact?

The same shift can have different effects depending on the economy’s starting point.

If the economy begins with a negative output gap, a rise in AD is more likely to increase real GDP and reduce unemployment with limited inflation. There is spare capacity, so firms can expand output without bidding up wages and input prices too much.

If the economy is already close to full capacity, a rise in AD is more likely to cause inflation. Output cannot expand much beyond potential in a sustainable way, so demand-pull inflation becomes the main effect.

The shape of AS also matters. A steep SRAS curve means AD increases mostly raise prices. A flatter SRAS curve means AD increases mostly raise output. This is why Keynesian economists argue that demand management can be effective in a recession, while neo-classical economists are more cautious about inflationary effects.

Policy response matters too. The Bank of England may raise interest rates to reduce AD if inflation is above target, but this can reduce investment, consumption and growth. Fiscal expansion can support demand, but may increase government borrowing. Supply-side policies can shift LRAS right, but they often take years to work.