Between late 1973 and early 1974 the price of oil roughly quadrupled, and economies across the developed world discovered something their economists had half believed impossible: prices rising fast while output fell and unemployment climbed. In 2020 output collapsed almost everywhere in a matter of weeks, and prices barely moved. Two shocks, two completely different outcomes. One diagram explains both, and it is the diagram behind almost every macroeconomic question on the paper: aggregate demand against aggregate supply.
Aggregate demand (AD)
The total planned spending on an economy's goods and services at each possible price level over a given period.
AD = C + I + G + (X - M)C is consumption by households, I is investment by firms in capital goods, G is government spending on goods and services, and X - M is net exports, spending by foreigners on domestic output minus spending by residents on imports. Transfer payments such as pensions are not part of G, because they buy no output; they affect AD only when the recipients spend them.
The AD curve slopes downwards, but not for the reason a demand curve for a single good does. A single good becomes relatively cheaper when its price falls, so people switch towards it. When the whole price level falls, nothing becomes relatively cheaper at home, so a different explanation is needed, and there are three. The wealth effect: a lower price level raises the real value of people's savings, so they feel richer and spend more. The interest rate effect: at a lower price level people need less money for transactions, so more is available to lend, interest rates fall, and borrowing for consumption and investment rises. The international trade effect: a lower price level makes domestic goods cheaper than foreign ones, so exports rise and imports fall.
Asked why AD slopes downwards, many candidates write that 'people buy more when prices are lower', which is the reasoning for a single good and earns nothing here. Name at least two of the wealth, interest rate and international trade effects and explain each in a sentence. Label the axes 'price level' and 'real output' or 'real GDP', never 'price' and 'quantity': the wrong labels tell the examiner you have drawn a micro diagram.
A change in the price level moves the economy along the AD curve. Anything else that changes planned spending shifts the whole curve. AD shifts right when consumer or business confidence rises, when interest rates fall, when income tax is cut, when house prices or share prices rise and people feel wealthier, when the government spends more, when incomes abroad rise so foreigners buy more exports, and when the exchange rate falls so exports become cheaper and imports dearer. The same changes in reverse shift it left. The skill examiners test is naming which component moves: a cut in interest rates shifts AD because it raises C and I, not simply because 'spending rises'.
Which of the following would cause a movement along the AD curve rather than a shift of it?
Aggregate supply (AS)
The total output of goods and services that firms in an economy are willing and able to produce at each possible price level over a given period.
In the short run, short-run aggregate supply (SRAS) slopes upwards. The short run here is the period in which the prices of inputs, above all money wages, are fixed by contracts and have not yet adjusted. If the price level of output rises while wages stay the same, each unit sold earns more relative to its cost, so firms find it profitable to produce more. SRAS shifts when the costs of production change at every level of output: a rise in money wages, in the price of imported raw materials or energy, in indirect taxes, or a fall in the exchange rate that makes imported inputs dearer, shifts SRAS left. Lower costs, subsidies or a rise in productivity shift it right.
Long-run aggregate supply (LRAS) represents the economy's productive capacity, the output it can produce when all resources are fully employed. There are two ways of drawing it, and the syllabus expects both. The classical or monetarist view draws LRAS vertical at the full employment level of output, on the argument that in the long run wages and prices adjust so that output returns to capacity whatever the price level. The Keynesian view draws it in three sections: horizontal at low output, where there is so much spare capacity that output can rise with no increase in the price level; upward sloping in the middle, as bottlenecks appear and some firms reach capacity before others; and vertical at full capacity, where output cannot rise at all. LRAS shifts right when the quantity or quality of the factors of production rises, through investment, education and training, new technology, immigration or better institutions, and it shifts left when capacity is destroyed or lost.
Draw two diagrams with the price level on the vertical axis and real output on the horizontal axis. On the first, draw a downward-sloping AD curve, an upward-sloping SRAS curve and a vertical LRAS curve, with all three meeting at full employment output. On the second, draw a Keynesian AS curve in three sections, label the horizontal, intermediate and vertical sections, and draw three AD curves cutting it in each section.
Label the full employment level of output, usually Yfe, on both. The second diagram is the one you will use most, because it lets you say that the effect of any change in AD depends on where the economy starts.
Macroeconomic equilibrium is where AD meets AS, which determines two things at once: the level of real output and the price level. Employment follows from output, because labour is a derived demand: firms producing more need more workers. The model's value lies in comparing equilibria. A rightward shift of AD raises real output and employment if there is spare capacity, and raises the price level if there is not. A leftward shift of SRAS, caused by a rise in costs, raises the price level and reduces output at the same time. A rightward shift of LRAS raises capacity, so output can grow while the price level stays stable or falls.
Finding equilibrium and the effect of a rise in AD from a table
An economy has the following aggregate demand and short-run aggregate supply, with real output in $ billion. Price level 100: AD 900, SRAS 820. Price level 105: AD 880, SRAS 840. Price level 110: AD 860, SRAS 860. Price level 115: AD 840, SRAS 880. Price level 120: AD 820, SRAS 900. Full employment output is $880 billion. Find the equilibrium. Then find the new equilibrium if AD rises by $40 billion at every price level, and describe what happened.
How an oil price shock causes stagflation
- The world price of oil rises sharply.
- Energy and transport are inputs to almost every good, so firms' costs of production rise across the economy.
- At every price level firms are now willing to supply less, so SRAS shifts to the left.
- At the old price level there is excess demand, so the price level rises.
- As the price level rises, the quantity of real output demanded falls, a movement up along the AD curve.
- The new equilibrium has a higher price level and a lower level of real output.
- Lower output means firms need fewer workers, so unemployment rises at the same time as inflation: stagflation.
This is why a supply shock is so hard for policymakers. Raising AD to fight the unemployment makes the inflation worse; cutting AD to fight the inflation makes the unemployment worse. No demand-side policy fixes both.
Practise this chain →Draw an AD/AS diagram in equilibrium. Show the effect of a sharp rise in import prices on SRAS, and mark the change in the price level and in real output. On a second diagram, show the effect of a large programme of investment in education and training on LRAS, and mark the same two changes.
The contrast is the lesson. Both are supply-side changes, but one raises prices and cuts output while the other lowers prices and raises output. Candidates who can show both on diagrams can answer almost any question about growth or inflation.
An economy is operating on the horizontal section of a Keynesian aggregate supply curve. What is the most likely effect of a rise in government spending?
Applied context
The inflation that began in 2021 is useful because both curves moved at once. As economies reopened after the pandemic, household spending recovered strongly, helped by savings built up during lockdowns and by government support, which shifted AD right. At the same time, disrupted supply chains, shortages of components and then a sharp rise in energy prices raised firms' costs, which shifted SRAS left. Both shifts push the price level up, which is why inflation rose so far in so many countries together. They push output in opposite directions, which is why the effect on growth was much less clear than the effect on prices.
Use this to show that a real episode often combines demand and supply shocks, and that identifying which one dominates decides which policy response is right.
Almost every macro question can be answered through this diagram, but only if you state the starting position. 'Expansionary policy shifts AD right, raising output' is incomplete. Say whether the economy is on the elastic or the inelastic part of AS, then say how the shift divides between output and the price level. That one sentence is what separates an analysis mark from a description.
How useful is the AD/AS model?
- Its strength is that one diagram shows output, the price level and, through output, employment together, and can represent demand shocks, supply shocks and policy on the same axes. Few models do that much so simply.
- Against that, the shape of AS, which decides almost every conclusion, is disputed. On a classical vertical LRAS, demand policy affects only prices in the long run; on the Keynesian curve it can raise output substantially. The diagram does not settle which is right.
- It is static. It compares two equilibria but says nothing about how long the move between them takes, and timing is often the most important question for policy.
- The curves are not independent in reality. A rise in investment shifts AD now and LRAS later, and a fall in the exchange rate shifts AD right while shifting SRAS left, so a single cause can move more than one curve.
- The strongest answers use the model to reason about the direction and relative size of effects, and state the assumption about AS they are making, rather than treating any diagram as a prediction.