Why this model matters

Why do economies sometimes grow fast with rising inflation, and sometimes shrink with falling prices? Why did inflation jump after the pandemic, and why can an oil shock bring higher prices and job losses at once? The aggregate demand–aggregate supply (AD–AS) model is the standard tool for answering these questions. It appears in almost every macroeconomics textbook, from OpenStax to Mankiw and Blanchard.

The model looks like supply and demand for a single market, but it describes the whole economy: total output (real GDP) and the overall price level.

Aggregate demand

Aggregate demand is total spending on the economy's output at each price level:

AD = C + I + G + (X - M)

It slopes downward. When the overall price level falls:

Wealth effect: money and savings buy more, so people spend more.
Interest rate effect: people need less money for transactions, so interest rates tend to fall, encouraging investment.
Exchange rate effect: domestic goods become cheaper relative to foreign ones, boosting exports.

AD shifts when spending changes at every price level: consumer and business confidence (animal spirits), credit conditions, interest rates set by the central bank, government spending and taxes, and demand from abroad.

Aggregate supply: short run and long run

Aggregate supply has two versions.

Short-run aggregate supply (SRAS) slopes upward. Many wages and prices are sticky: contracts and habits mean they adjust slowly. When prices rise, firms' revenues rise before their costs catch up, so producing more is profitable.
Long-run aggregate supply (LRAS) is vertical at potential output: what the economy can produce with its labor, capital and technology when all prices have adjusted. In the long run, the price level does not change how much the economy can make.

SRAS shifts with input costs (wages, energy, raw materials), productivity and supply shocks. LRAS shifts only with the economy's real capacity: more workers, more capital, better technology, as in the Solow growth model.

Equilibrium

Short-run equilibrium is where AD meets SRAS. Take a simple example where output demanded is $Y = 2{,}000 - 10P$ and short-run supply is $Y = 10P$ , with $P$ the price level (an index) and $Y$ real output in billions:

2{,}000 - 10P = 10P \quad\Rightarrow\quad P = 100, \quad Y = 1{,}000

Aggregate demand and short-run supply (real output, billions)

Aggregate demand and short-run supply (real output, billions)
	P=90	P=95	P=100	P=105	P=110	P=115	P=120
Aggregate demand	1,100 bn	1,050 bn	1,000 bn	950 bn	900 bn	850 bn	800 bn
Aggregate demand after a boom	1,300 bn	1,250 bn	1,200 bn	1,150 bn	1,100 bn	1,050 bn	1,000 bn
Short-run aggregate supply	900 bn	950 bn	1,000 bn	1,050 bn	1,100 bn	1,150 bn	1,200 bn

If potential output is also 1,000, the economy is in long-run equilibrium: no output gap, and unemployment at its natural rate.

Shock 1: a demand boom

Suppose confidence and credit surge, raising spending by 200 at every price level, so $Y = 2{,}200 - 10P$ . The new short-run equilibrium is $P = 110$ and $Y = 1{,}100$ : output rises above potential and prices rise 10%. Unemployment falls below its natural rate.

That cannot last. With the economy overheating, workers and firms push for higher wages and prices, SRAS shifts left, and output drifts back toward potential at an even higher price level. The long-run result of a pure demand boom is higher prices, not more output.

Shock 2: a demand bust

Run the story in reverse. A financial crisis or collapse in confidence shifts AD left. Output falls below potential, unemployment rises, and inflation slows. Because wages and prices are sticky downward, the return to potential can be slow and painful. This is the situation Keynes worried about, and the main case for stabilization policy.

Demand shocks move output and prices in the same direction. Supply shocks move them in opposite directions.

Shock 3: a supply shock

Now suppose oil prices jump. Production costs rise everywhere, so SRAS shifts left. The result is the worst of both: higher prices and lower output, known as stagflation. The 1970s oil shocks are the textbook example.

Supply shocks put central banks in a bind. Fighting inflation with higher interest rates deepens the fall in output; supporting output risks letting inflation become entrenched.

Shock	Price level	Output (short run)	Example
AD rises	Up	Up	Credit boom, tax cuts
AD falls	Down	Down	Financial crisis
SRAS falls	Up	Down	Oil price spike
LRAS rises	Down	Up (lasting)	Productivity growth

What policy can do

Monetary policy shifts AD. Lower interest rates boost borrowing and spending; higher rates cool them. See what the Fed does with interest rates and the Taylor rule.
Fiscal policy shifts AD through government spending and taxes, amplified by the fiscal multiplier and partly offset by crowding out. Automatic stabilizers act without new laws.
Supply-side policies, such as education, infrastructure, research and competition, shift LRAS, raising potential output over time.

Policy can smooth demand shocks reasonably well. It cannot undo a supply shock without trade-offs, and it cannot raise long-run output simply by stimulating demand.

Limits of the model

AD–AS is a simplification. It treats the economy as producing one good, it compresses expectations into the position of SRAS, and it says little about financial markets or the speed of adjustment. Intermediate textbooks add the IS–LM model for interest rates, the Phillips curve for inflation dynamics, and rational expectations for how anticipated policy changes behavior.

Key ideas to remember

AD slopes down; SRAS slopes up; LRAS is vertical at potential output.
Demand shocks move prices and output together; supply shocks move them apart.
In the long run, output returns to potential and demand shocks change only prices.
Monetary and fiscal policy shift AD; only higher productivity and capacity shift LRAS.

The AD–AS Model: How Economists Explain Booms, Busts and Inflation