Aggregate Demand and Aggregate Supply
In one line. Aggregate demand is the total planned spending on an economy at each general price level, and aggregate supply is the total planned output. Where the two curves cross sets the general price level and real national output, and the shape of the Keynesian AS curve decides how a shift splits between output and prices.
Exam relevance: one of the highest-yield macro themes, a recurring essay and case-study topic in recent A Level papers, on ETG analysis. Taught the way an economics tutor who wrote the answer keys teaches it.
01What AD and AS are
Macroeconomics models the whole economy with two curves, aggregate demand and aggregate supply, and where they cross sets the general price level and real national output at once.
Aggregate demand (AD) is the total planned expenditure on an economy's final goods and services at each general price level, over a period of time.
Aggregate supply (AS) is the total planned output producers are willing and able to supply at each general price level.
02The components of AD
Aggregate demand is the sum of four kinds of planned spending, captured in one master identity.
AD = C + I + G + (X - M)
- C, consumption. Household spending on goods and services, the largest component in most economies.
- I, investment. Firms' spending on capital such as machinery, buildings and stock.
- G, government spending. State spending on goods and services.
- (X - M), net exports. Export revenue minus import spending, positive or negative.
A change in any component, at a given price level, shifts the whole AD curve. That is the link between the components here and the shifts in section six.
03Why the AD curve slopes down
The AD curve slopes downward for three economy wide reasons, not for the single market reasons behind an ordinary demand curve.
- The real wealth effect. A lower price level raises the real value of money held, so households feel wealthier and spend more.
- The interest rate effect. A lower price level reduces money demand, tending to lower interest rates and encourage investment.
- The international trade effect. A lower domestic price level makes exports cheaper and imports dearer, raising net exports.
04The Keynesian AS curve
Aggregate supply is drawn Keynesian-shaped: flat when there is spare capacity, rising as the economy nears capacity, and vertical at full employment output Yf.
The shape is the whole point. On the flat region, idle resources meet extra demand, so output rises with no price pressure. As the economy approaches Yf, resources grow scarce, so extra demand pulls prices up. At Yf, output cannot rise and any extra demand is purely inflationary. You read the result of any shift straight off the position on this curve, which is exactly what the diagrams below show.
05The macroeconomic equilibrium
The macroeconomic equilibrium is the price level at which planned spending equals planned output, where the AD curve crosses the AS curve. Push the economy away from it and the resulting glut or shortage of demand pushes it back.
06What shifts aggregate demand
The AD curve moves when any component of C + I + G + (X - M) changes at a given price level.
- Consumption. Consumer confidence, income tax, household wealth, credit.
- Investment. Interest rates, business confidence, expected demand.
- Government spending. The fiscal stance for the year.
- Net exports. The exchange rate and foreign income.
Name the component, then the determinant, then the direction. "Higher consumer confidence raises planned consumption, so AD shifts rightward" scores. Writing only "AD increases" does not.
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07Demand-pull inflation
A rightward shift of AD raises real output, the price level, or both, and which one depends entirely on where the economy sits on the Keynesian AS curve.
- Trigger. The government raises infrastructure spending, so G rises.
- Shift. AD shifts rightward to AD1.
- Outcome. A new equilibrium at a higher price level and higher real output, with the split set by how close the economy is to Yf, as the two figures show.
08Cost-push inflation
A fall in aggregate supply, from higher costs of production, shifts the AS curve up and raises the price level while reducing output.
A rightward AD shift raises prices and output together. A leftward AS shift raises prices but cuts output. Reading which curve moved is how you tell demand-pull from cost-push.
09Common misconceptions
A change in the price level is a movement along AD, not a shift of it. Only a change in C, I, G or net exports at a given price level shifts the whole curve.
The second frequent error is to draw a straight AS line. The Singapore H2 model answers use the Keynesian AS shape, because only that shape lets the marker see whether a shift lands in the spare-capacity, the rising, or the full-employment region.
10Test yourself
- Using a Keynesian AD/AS diagram, explain how a fall in interest rates affects the equilibrium.
- Distinguish, with diagrams, between demand-pull and cost-push inflation.
- Why does the same rise in AD cause more inflation near full employment than in a deep recession?
11Questions students ask
Demand is for a single good at each price of that good. Aggregate demand is the total planned spending on all of an economy's final goods and services at each general price level. The axes differ: a demand diagram uses the price and quantity of one good, an AD diagram uses the general price level and real national output.
Not always. If the economy has spare capacity, a rise in AD mainly raises real output with little pressure on the price level, the flat part of the Keynesian AS curve. The closer the economy is to full employment, the more an AD increase shows up as a higher price level. The shape of AS decides the split.
Demand-pull inflation comes from a rightward shift of AD, so the price level and real output both rise. Cost-push inflation comes from a leftward shift of AS, usually higher costs of production, so the price level rises while real output falls. Identifying which curve moved is the first mark in most macro questions.