Source: Chapter 12, Principles of Macroeconomics (University of Florida)
Tags: aggregate demand, aggregate supply, AD-AS model, short-run aggregate supply, long-run aggregate supply, SAS, LAS, business cycle, output gap, recessionary gap, inflationary gap, expansionary gap, macroeconomic equilibrium, potential GDP, sticky prices, price level, real GDP
Difficulty: Intermediate | Prerequisites: GDP and how it is measured (Ch. 4–5), basic supply and demand (Ch. 3), the price level and inflation (Ch. 9–10).
This chapter introduces the AD-AS model, which is the central framework macroeconomics uses to explain fluctuations in real GDP and the overall price level. Everything you have learned so far about GDP measurement, inflation, and the business cycle feeds into this model. If microeconomics gave you supply and demand for a single market, this chapter scales that logic up to the entire economy, with some important differences (sticky prices, the distinction between short-run and long-run supply). Mastering AD-AS is essential because almost every policy discussion in the rest of the course, whether fiscal or monetary, is argued on this diagram.
Aggregate demand slopes downward: a higher price level means less real GDP demanded. Aggregate supply behaves differently depending on the time horizon, because input prices are sticky in the short run but fully flexible in the long run. The economy self-corrects toward potential GDP over time, but the adjustment works through shifts in short-run aggregate supply driven by changing input costs.
Aggregate demand (AD)
The total quantity of real GDP demanded at each price level, representing the spending side of the economy. Think of it as the economy-wide demand curve: it slopes downward because a higher price level reduces purchasing power, raises interest rates, and makes domestic goods more expensive relative to imports.
Aggregate supply (AS)
The total quantity of real GDP that firms are willing to produce at each price level, representing the production side of the economy. It splits into a short-run version and a long-run version.
Short-run aggregate supply (SAS)
The upward-sloping supply curve that applies while input prices (wages, raw materials, contracts) remain sticky. In simple terms, when the price level rises but costs have not caught up yet, firms earn higher margins and want to produce more.
Long-run aggregate supply (LAS)
A vertical line at potential GDP. Once all input prices have fully adjusted to the price level, a higher price level no longer makes production more profitable, so the quantity supplied does not change. Think of it as the economy's speed limit.
Sticky prices
The observation that wages and other input costs do not adjust immediately when the general price level changes, often because of existing contracts or slow renegotiation. This is the key reason the short-run aggregate supply curve slopes upward rather than being vertical.
Potential GDP
The level of real GDP the economy produces when all factors of production (labour, capital, land) are employed at their normal, sustainable rates. It is not the maximum possible output; it is the output consistent with stable inflation.
Output gap
The difference between actual real GDP and potential GDP. A positive gap is expansionary; a negative gap is recessionary.
Expansionary gap (inflationary gap)
The situation where real GDP exceeds potential GDP. The economy is running above its sustainable capacity, which puts upward pressure on input prices.
Recessionary gap
The situation where real GDP falls below potential GDP. Resources are underused, and input prices face downward pressure.
Long-run macroeconomic equilibrium
The state in which real GDP equals potential GDP. The AD curve, SAS curve, and LAS line all intersect at the same point.
Recession
Defined as negative GDP growth (a falling real GDP) for at least two consecutive quarters, or roughly six months.
Recovery
The phase where GDP growth turns positive again after a recession, but real GDP has not yet returned to potential GDP. The economy is growing, but the recessionary gap persists.
The AD curve shows the inverse relationship between the price level and real GDP demanded. It shifts when any of the following change (holding the price level constant):
Expectations: changes in household or business expectations about future income, profits, or inflation
Fiscal policy: government expenditure, tax rates, transfer payments
Monetary policy: the quantity of money in circulation, interest rates set or influenced by the central bank
The world economy: currency exchange rates, income levels in trading-partner countries
A rightward shift means more real GDP is demanded at every price level. A leftward shift means less.
In the short run, when the price level rises, the prices firms receive for their output go up, but the prices they pay for inputs (wages, materials, rent) are sticky. The gap between rising revenue and unchanged costs raises profit margins, so firms increase production.
In the long run, input prices renegotiate and catch up to the new price level. Once costs have fully adjusted, there is no extra profit from a higher price level, and output returns to potential GDP.
The SAS curve is upward-sloping. The LAS curve is vertical at potential GDP.
LAS shifts (changes in potential GDP itself):
Changes in the full-employment quantity of labour
Changes in the quantity of physical capital
Advances in technology
These shift both LAS and SAS to the right.
SAS-only shifts (no change in potential GDP):
A change in the money wage rate or other factor costs
A rise in wages shifts SAS left (higher costs reduce the quantity firms will supply at any given price level)
A fall in wages shifts SAS right
This does not move LAS, because in the long run, the price level adjusts proportionally and there is no relative price difference to alter supply
The business cycle is the repeated pattern of real GDP fluctuating above and below potential GDP over time. Three states matter:
Expansionary (inflationary) gap: real GDP > potential GDP
Recessionary gap: real GDP < potential GDP
Long-run equilibrium: real GDP = potential GDP
The economy tends to return to potential GDP without policy intervention, though the process can be slow:
Closing an expansionary gap:
Factors of production, especially labour, are in short supply
Input prices and wages rise
Higher costs squeeze profits, so firms cut back production
The SAS curve shifts left until it intersects AD at potential GDP
Closing a recessionary gap:
Factors of production are in surplus
Input prices and wages fall
Lower costs improve profitability, so firms expand production and hiring
The SAS curve shifts right until it intersects AD at potential GDP
No algebraic formulas are required for this chapter. The essential diagrams are:
AD curve: downward-sloping, with price level on the vertical axis and real GDP on the horizontal axis
SAS curve: upward-sloping, same axes
LAS curve: vertical line at potential GDP, same axes
Expansionary gap diagram: AD and SAS intersect to the right of LAS
Recessionary gap diagram: AD and SAS intersect to the left of LAS
Long-run equilibrium diagram: AD, SAS, and LAS all intersect at the same point
Be able to draw each of these from memory and label the axes, curves, and the equilibrium price level and output.
Sticky wages explain why a sudden spike in oil prices (a supply shock) can push the economy into a recession: firms face higher costs but cannot instantly cut wages to compensate, so they reduce output instead. The self-correction mechanism is what classical economists point to when they argue the government should not intervene in recessions, on the grounds that wages will eventually fall and restore full employment on their own.
Students often confuse a movement along the AD curve (caused by a change in the price level) with a shift of the AD curve (caused by a change in expectations, policy, or the world economy). A price-level change does not shift AD; it causes movement along it.
Students sometimes treat the LAS as a maximum output the economy can never exceed. In fact, real GDP regularly exceeds potential GDP during an expansionary gap. Potential GDP is a sustainable level, not a ceiling.
Students frequently forget that a change in the money wage rate shifts only the SAS, not the LAS. The logic is that in the long run, price levels adjust proportionally, so there is no relative cost change to move the vertical curve.
Students sometimes believe the economy corrects instantly. The self-correction mechanism works through gradual wage and input-price adjustments, which can take years.
⚠️ Be prepared to identify whether a given event shifts AD, SAS, LAS, or some combination, and in which direction.
⚠️ Expect questions that ask you to trace the self-correction process step by step: starting position, which curve shifts, direction of shift, new equilibrium.
⚠️ Know the definition of a recession (two consecutive quarters of negative GDP growth) and how it relates to the recessionary gap on the AD-AS diagram.
⚠️ The difference between the short run and the long run in this model is entirely about whether input prices have adjusted. That is the single most important conceptual distinction in the chapter.
True or false: The long-run aggregate supply curve slopes upward.
Fill in the blank: A recessionary gap exists when real GDP is __________ potential GDP.
True or false: An increase in government spending shifts the AD curve to the right.
Fill in the blank: The key reason the SAS curve slopes upward is that input prices are __________ in the short run.
True or false: A rise in the money wage rate shifts the LAS curve to the left.
Answers: 1. False (it is vertical). 2. less than. 3. True. 4. sticky. 5. False (it shifts only the SAS to the left).
Q: What is the fundamental reason the short-run aggregate supply curve slopes upward?
A: Input prices (wages, materials, contracted costs) are sticky in the short run. When the price level rises, firms' revenues increase but their costs do not change immediately, so profit margins widen and firms increase production.
Q: Describe the self-correction process that closes a recessionary gap.
A: In a recessionary gap, real GDP is below potential GDP, so factors of production are in surplus. The surplus pushes input prices and wages downward. Lower costs make production more profitable, encouraging firms to expand output and hire more workers. The SAS curve shifts to the right until it intersects the AD curve at potential GDP, restoring long-run equilibrium.
Q: An economy experiences a large increase in consumer confidence. Which curve shifts, and in which direction? What happens to the price level and real GDP in the short run?
A: Higher consumer confidence increases spending at every price level, shifting AD to the right. In the short run, both the price level and real GDP rise as the economy moves along the upward-sloping SAS curve.
Q: Explain why a change in the money wage rate shifts the SAS but not the LAS.
A: The SAS depends on the gap between output prices and input costs. A wage increase raises costs and shifts SAS left. The LAS, however, is determined by the economy's productive capacity at full price adjustment. In the long run, the price level adjusts proportionally to the wage change, so there is no change in relative prices and no reason for the quantity supplied at potential GDP to change.
Q: What distinguishes a recession from a recessionary gap?
A: A recession is defined by the direction of change: negative GDP growth for at least two consecutive quarters. A recessionary gap is defined by the level: real GDP is below potential GDP. A recessionary gap can persist even during a recovery (positive growth), as long as real GDP has not yet reached potential GDP.
This chapter connects directly to fiscal policy (Ch. 13) and monetary policy (Ch. 14–15), both of which operate by shifting the AD curve. Understanding how the AD-AS model works is a prerequisite for evaluating whether government intervention speeds up or complicates the self-correction process. The concept of sticky prices also links back to the discussion of inflation measurement (Ch. 9), since the lag between output-price changes and input-price changes is central to both topics.
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