Aggregate demand and aggregate supply (AD-AS)
AD shows total spending at each price level; AS shows total output supplied. Their crossing sets real GDP and prices, and explains inflation, unemployment and growth.
Aggregate demand
Aggregate demand (AD) is the total planned spending on a country's goods and services at each price level: AD = C + I + G + (X − M). It slopes downwards for three reasons: the wealth (real balance) effect, as a lower price level raises the real value of savings; the interest rate effect, as lower prices reduce money demand and interest rates, encouraging borrowing; and the foreign trade effect, as lower domestic prices make exports cheaper and imports dearer. A change in the price level causes a movement along AD; a change in any other factor shifts it.
Factors that shift AD and AS
| Shifts AD | Shifts SRAS | Shifts LRAS |
|---|---|---|
| Consumer confidence and household wealth | Wage rates and other input costs | Size and skills of the labour force |
| Interest rates and credit (monetary policy) | Prices of imported fuel and raw materials | Stock of capital (machines, roads, ports) |
| Government spending and taxes (fiscal policy) | Exchange rate: a weaker rupee raises import costs | Technology and productivity |
| Exchange rate and incomes in export markets | Supply shocks: droughts, floods, disease | Institutions, education and the quality of governance |
| Workers' remittances and expectations | Indirect taxes and subsidies on production | Natural resources and land use |
Aggregate supply and equilibrium
Short-run aggregate supply (SRAS) slopes upwards: when the price level rises and wages are slow to adjust, production becomes more profitable and firms supply more. Long-run aggregate supply (LRAS) is vertical at potential (full-employment) output, because in the long run wages and prices fully adjust, so output depends only on resources and technology. Short-run equilibrium is where AD meets SRAS. If it is below potential output there is a recessionary (deflationary) gap with unemployment; if above, an inflationary gap. In the long run, wages adjust, SRAS shifts, and the economy returns to LRAS. Keynesians add that at deep recession levels AS is nearly flat, so extra demand raises output without much inflation.
Worked example: shifts in AD and SRAS
An economy has AD: Y = 1,000 − 4P and SRAS: Y = 200 + 4P (Y = real GDP in Rs. billion, P = price index). Potential output is 650. (a) Find the equilibrium and any output gap. (b) AD rises to Y = 1,100 − 4P. (c) Instead, an oil price rise shifts SRAS to Y = 120 + 4P.
- (a) 1,000 − 4P = 200 + 4P → 800 = 8P → P = 100. Y = 1,000 − 400 = 600. Gap = 650 − 600 = 50: a recessionary gap.
- (b) 1,100 − 4P = 200 + 4P → 900 = 8P → P = 112.5. Y = 1,100 − 450 = 650. Output reaches potential, but the price level rises 12.5%.
- (c) 1,000 − 4P = 120 + 4P → 880 = 8P → P = 110. Y = 1,000 − 440 = 560.
- In (c) prices rise from 100 to 110 while output falls from 600 to 560: stagflation.
(a) P = 100, Y = 600, recessionary gap 50. (b) Demand rise: P = 112.5, Y = 650 (gap closed, with demand-pull inflation). (c) Cost shock: P = 110, Y = 560 (stagflation).
A cost-push shock in the AD-AS model
This is stagflation: higher inflation and higher unemployment together.
Using AD-AS to explain the big three
| Issue | What happens in the model | Typical cause |
|---|---|---|
| Demand-pull inflation | AD shifts right near full capacity: P rises | Rapid credit growth, large budget deficits, boom in spending |
| Cost-push inflation | SRAS shifts left: P rises, Y falls | Oil price rise, rupee depreciation, wage push |
| Unemployment (recession) | AD shifts left or stays low: Y below potential | Falling confidence, tight policy, fall in exports |
| Economic growth | LRAS (and SRAS) shift right: Y rises without inflation | More capital, skills, technology, better institutions |
Sri Lanka imports its fuel, so a rise in world oil prices or a weaker rupee raises costs for transport, factories and bakeries alike: SRAS shifts left. Firms such as Hayleys or Cargills then face higher costs and weaker demand at the same time, which is why cost-push shocks hurt businesses so much.
Short answer: “Why does the long-run aggregate supply curve slope vertically?” In the long run wages and prices fully adjust, so output depends only on resources and technology (potential output), not on the price level.
Structured question: “State five factors that shift aggregate demand.” Consumer confidence and wealth, interest rates, government spending and taxes, exchange rate and foreign incomes, remittances and expectations.
Essay: “Using the AD-AS model, explain inflation, unemployment and economic growth.” Define AD, SRAS and LRAS with their shifters, show equilibrium and output gaps, then demand-pull and cost-push inflation, recessionary unemployment and growth as LRAS shifting right.
AD right → prices and output up. SRAS left → prices up, output down (stagflation). LRAS right → growth without inflation.