Chapter 9 · Aggregate demand and aggregate supply
AD–AS equilibrium
Find macroeconomic equilibrium where aggregate demand meets short-run aggregate supply. Read the equilibrium price level and real GDP.
The economic idea
Aggregate demand is the total planned expenditure on domestically produced goods and services at different average price levels during a period. It consists of consumption, investment, government spending and net exports, expressed as AD = C + I + G + (X − M).
The aggregate demand curve slopes downward because a lower domestic price level, ceteris paribus, raises the real value of money balances, can reduce interest rates and makes domestic output more competitive internationally. These effects encourage planned expenditure; they are not the same explanation as diminishing marginal utility in a single market.
Short-run aggregate supply is the total real output firms are willing and able to produce at different average price levels while at least one input price remains fixed. It slopes upward because a higher output price level can raise profit margins when wages and other input costs adjust more slowly.
Short-run macroeconomic equilibrium occurs where aggregate demand equals short-run aggregate supply. Planned expenditure then matches firms’ intended production, determining equilibrium real GDP and the average price level.
The equilibrium can occur below, at or above potential output. Without a measure of potential output such as LRAS, this two-curve diagram alone cannot identify the sign of an output gap.
Reading short-run macroeconomic equilibrium at E
“Price level” is measured vertically. It is an index of the average prices of final goods and services, not the money price of one good.
“Real GDP” is measured horizontally and represents inflation-adjusted national output.
“AD” records total planned expenditure at each price level. “SRAS” records total planned production in the short run.
The spending side: AD
“AD” combines consumption, investment, government expenditure and net exports. A movement along it is caused by a change in the price level; a change in any non-price determinant shifts the entire curve.
The production side: SRAS
“SRAS” is upward sloping because selling prices can change before nominal wages and other input costs fully adjust. Firms therefore have an incentive to expand real output as the price level rises, up to capacity constraints.
The intersection: E
“E” is where “AD” intersects “SRAS”. It establishes the short-run equilibrium price level “Pₑ” and real output “Qₑ” because planned expenditure equals the output firms are willing to produce.
What does equilibrium tell us about well-being?
Equilibrium means spending plans and production plans agree at that price level. It does not mean that income is shared fairly, that every worker has a job or that the economy produces the socially best mix of goods.
Use the two axes to report the output and price-level outcome. Evidence about potential output, distribution or environmental effects is needed before making those wider judgements.
How the economy reaches the displayed equilibrium
At a price level above “Pₑ”, planned production on “SRAS” exceeds planned expenditure on “AD”. Unplanned inventories encourage firms to reduce prices and output.
At a price level below “Pₑ”, planned expenditure exceeds current production. Inventories fall and firms respond by raising prices and expanding output.
The process continues until “AD” equals “SRAS” at “E”, producing “Pₑ” and “Qₑ”.
Common mistakes to avoid
- Do not label the vertical axis price. It represents the average price level across the economy.
- AD is not simply consumer demand. It includes investment, government spending and net exports as well as consumption.
- A point where AD meets SRAS is short-run equilibrium, but it is not automatically full-employment equilibrium.
- Do not use the law of demand for one good to explain the downward slope of aggregate demand.
How to draw this diagram
- Title the diagram “AD–AS equilibrium”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw SRAS next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The curves combine many markets and cannot show sectoral differences, distributional effects or regional unemployment.
- The speed and size of adjustment depend on expectations, confidence, spare capacity and the flexibility of wages and prices.
- Potential output is not shown, so the model cannot diagnose an output gap on its own.
- The model is static and does not show time lags between expenditure decisions, production and the price level.
- External shocks can move AD and SRAS simultaneously, making the isolated two-curve story incomplete.