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The Aggregate Supply–Aggregate Demand (AS-AD) model describes the simultaneous determination of the price level and real GDP in the short and long run. Short-run equilibrium occurs where AD intersects SRAS; long-run equilibrium requires that intersection to also lie on LRAS (at potential output). Demand shocks (AD shifts) and supply shocks (SRAS shifts) produce different combinations of output and price-level changes, helping explain why some economic downturns are accompanied by high inflation (stagflation) and others are not.
Practice the four standard shock scenarios: (1) positive demand shock, (2) negative demand shock, (3) adverse supply shock, (4) favorable supply shock. For each, identify what happens to the price level and real GDP in the short run and what the self-correction path is.
You have already studied supply and demand in a single market — but that framework analyzes one price and one quantity. The AS-AD model lifts this to the entire economy, replacing "price" with "price level" (an index like the CPI) and "quantity" with "real GDP." The shape of the curves follows different logic than single-market S&D, so resist the temptation to treat it the same way.
The Aggregate Demand (AD) curve slopes downward, but not for the same reason as a firm's demand curve. Higher price levels reduce real wealth (the real balance effect), raise interest rates (the interest rate effect), and make domestic goods more expensive relative to foreign goods (the exchange rate effect). All three reduce spending, so higher price levels are associated with lower real GDP demanded. Shifts in AD come from changes in any of its components: consumption, investment, government spending, or net exports.
The Short-Run Aggregate Supply (SRAS) curve slopes upward because input prices (especially wages) are sticky in the short run. When the price level rises but wages haven't yet adjusted, firms' profit margins widen and they produce more. Shifts in SRAS come from changes in input costs (oil prices, wages) or supply shocks. The Long-Run Aggregate Supply (LRAS) curve is vertical at potential output because, in the long run, all prices are flexible and the economy produces at its capacity regardless of the price level.
The key scenarios to master are demand shocks versus supply shocks. A positive demand shock (say, a stimulus check) shifts AD right: output rises and price level rises in the short run. In the long run, wages catch up, SRAS shifts left, and output returns to potential at a permanently higher price level. A negative supply shock (an oil embargo) shifts SRAS left: output falls *and* price level rises simultaneously — this is stagflation, the nightmare combination that stumped policymakers in the 1970s. Notice that demand-side policies can fix the output gap or the price level, but not both at once when the problem originates on the supply side.
Self-correction provides a theoretical anchor: if policy does nothing, wages eventually adjust and SRAS drifts back to restore potential output. But "eventually" can mean years of high unemployment. The AS-AD model frames the central debate in macroeconomic policy: how long is the long run, and how much pain is acceptable while waiting for it?