The aggregate demand and aggregate supply (AD/AS) model is based on the work of British economist John Maynard Keynes. It is used to explain production and price levels in the macroeconomic framework. Although it is a simplified view of macroeconomic activity, the AD/AS model remains an important framework for economists and policymakers to use when understanding economic activity and policy solutions to economic problems.
At A Glance
Aggregate demand is the total quantity of goods and services that households, firms, the government, and foreign buyers demand at each price level at a given time.
- The aggregate demand curve slopes downward for three reasons: the wealth effect, the interest-rate effect, and the exchange-rate effect.
Shifts in the aggregate demand curve are caused by changes in consumption expenditures, investment expenditures, government expenditures, and imports and exports.
Aggregate supply is the sum of production in an economy in a specific time period. Aggregate supply behaves differently in the short run and the long run.
- Three main theories explain why short-run aggregate supply curves upward: sticky wages, sticky prices, and misconceptions.
Shifts in the short-run aggregate supply curve are ultimately caused by changes in labor, capital, natural resources, or technology or by changes in expectations of price levels.
Short-run macroeconomic equilibrium is achieved when aggregate demand and aggregate supply are equal in the short term.
- Macroeconomic analysis is divided into long-run and short-run analysis. The crucial difference is the role played by expected price level in affecting short-run aggregate supply curves.
- The long-run aggregate supply (LRAS) curve is a description of the relationship between the price level and the quantity of output produced in an economy over the long run.
- The long-run aggregate supply curve can shift when the productive potential of an economy changes because of factors such as increased resources or technological development, but not because of changes in price level.
Long-run macroeconomic equilibrium occurs when actual GDP is equal to potential GDP on the long-run aggregate supply curve. When real GDP is higher than potential GDP, an inflationary gap exists. When real GDP is lower than potential GDP, a recessionary gap exists.
Potential GDP corresponds with full employment and represents the greatest quantity of productive output that can be sustainably produced on an ongoing basis.
- Inflation in an economy can have various causes. When inflation occurs because of a decrease in aggregate supply because of an increase in production costs, it is called cost-push inflation. When inflation occurs because of an increase in aggregate demand, it is called demand-pull inflation.