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3.2

Aggregate demand and aggregate supply

Unit 3 · Macroeconomics · SL and HL

The AD/AS model is the macroeconomic equivalent of demand and supply, and you will use it in nearly every Unit 3 and Unit 4 answer. The tricky part is that there are two schools of thought on aggregate supply: the monetarist/new classical view, with a vertical long-run AS curve and automatic self-correction, and the Keynesian view, in which an economy can stay stuck in a recession. Know both diagrams and when each is appropriate.

🎯What you need to be able to do

  • Draw and explain the AD curve; explain its components C + I + G + (X − M) and their determinants; show shifts of AD.
  • Draw and explain the SRAS curve, its determinants (costs of factors of production, indirect taxes) and shifts.
  • Explain the monetarist/new classical LRAS and the Keynesian AS curve, and inflationary and deflationary (recessionary) gaps.
  • Explain the causes of shifts in LRAS / Keynesian AS: quantity and quality of factors, technology, efficiency and institutions.
  • Draw short-run and long-run equilibrium in both models: automatic adjustment and the natural rate of unemployment in the monetarist model; persistent deflationary gaps in the Keynesian model.
  • Evaluate the assumptions and implications of the two models.

📚The economics

Aggregate demand

Aggregate demand (AD) is the total planned spending on an economy’s final goods and services at each price level, in a given period.

\[ AD = C + I + G + (X - M) \]

The AD curve slopes downwards: at a lower average price level, the real value of households’ money and savings is higher (wealth effect), interest rates tend to be lower (interest rate effect, encouraging borrowing), and domestic goods are cheaper relative to foreign ones (trade effect). A change in the price level is a movement along AD; a change in any component shifts it.

Left: a downward-sloping AD curve with price level on the vertical axis and real GDP on the horizontal axis; a fall in the price level from PL1 to PL2 raises real output demanded from Y1 to Y2. Right: AD1 shifts right to AD2 when C, I, G or net exports rise, and left to AD3 when they fall.
Axes: average price level and real GDP, never “price” and “quantity”.

Determinants of the components of AD

  • Consumption (C), household spending, the largest component (over half of Indonesia’s GDP): consumer confidence; interest rates (the cost of borrowing and reward for saving); wealth (house and share prices); income taxes; household indebtedness; expectations of future prices.
  • Investment (I), firms’ spending on capital goods: interest rates; business confidence; technology (new processes to invest in); business taxes; corporate indebtedness.
  • Government spending (G): political and economic priorities (infrastructure programmes, stimulus during recessions, election promises such as Indonesia’s free school meals programme from 2025).
  • Net exports (X − M): incomes of trading partners (China’s growth drives demand for Indonesian coal and nickel); exchange rates (a weaker rupiah makes exports cheaper and imports dearer); trade policies (tariffs, trade agreements).

Short-run aggregate supply

SRAS shows the total output firms plan to produce at each price level in the short run, when the prices of factors of production, especially wages, are fixed (by contracts, for example). If the price level rises while costs stay fixed, production becomes more profitable, so output rises: SRAS slopes upwards.

Left: an upward-sloping SRAS curve, with a higher price level PL2 associated with higher real GDP Y2. Right: SRAS1 shifts right to SRAS2 when costs fall, and left to SRAS3 when costs rise.
SRAS shifts with the costs of production.

Shifts of SRAS come from changes in costs of factors of production (wages, rents, oil and other raw-material prices, imported inputs when the exchange rate falls) and indirect taxes (a rise in VAT shifts SRAS left). A subsidy to producers shifts it right. Supply shocks such as the 2022 energy price spike shift SRAS sharply left.

Two views of aggregate supply in the long run

Left, monetarist/new classical: a vertical LRAS at full-employment output Yf with an upward-sloping SRAS. Right, Keynesian: an AS curve that is horizontal at low output (section I, spare capacity), then curves upward (section II, bottlenecks), then becomes vertical at full employment Yf (section III).
The two schools disagree about how flexible wages and prices are.
Monetarist / new classical
In the long run, wages and prices are fully flexible. Output is determined by the economy’s resources and technology, not by the price level, so the LRAS is vertical at the full employment level of output (potential output, Yf). Changes in AD affect only the price level in the long run.
Keynesian
Wages and prices are sticky downwards (contracts, unions, minimum wages, reluctance to cut pay). The AS curve has three sections: I horizontal, with lots of spare capacity, so output can rise with no inflation; II rising, as bottlenecks and shortages of skilled labour appear; III vertical at full capacity.

Inflationary and deflationary gaps

Left: AD meets SRAS at Y1, to the left of the vertical LRAS at Yf; the gap between Y1 and Yf is a deflationary gap. Right: AD meets SRAS at Y2, to the right of Yf; the gap is an inflationary gap.
The gap is measured on the real GDP axis, between actual output and potential output.
  • Deflationary (recessionary) gap: equilibrium real GDP is below potential output. There is unemployment above the natural rate (cyclical unemployment) and spare capacity.
  • Inflationary gap: equilibrium real GDP is above potential output: firms use overtime, overstretch capacity and compete for scarce labour, so costs and prices rise.

Shifts of LRAS and the Keynesian AS

Left: a vertical LRAS1 shifting right to LRAS2, raising full-employment output from Yf1 to Yf2. Right: the Keynesian AS curve shifting right, so its vertical full-capacity section moves to a higher output.
Anything that raises the economy’s productive capacity shifts LRAS (or the Keynesian AS) right.
  • Quantity of factors of production: more labour (population growth, migration, higher participation), more capital (investment), new resources.
  • Quality of factors: education, training and health (human capital); better infrastructure.
  • Improvements in technology: automation, digital platforms, better seeds.
  • Increases in efficiency: more competition, better management, reallocation of resources to more productive uses.
  • Changes in institutions: secure property rights, less corruption and red tape, stable legal and banking systems, labour market reforms. (Supply-side policies, 3.7, target all of these.)

Macroeconomic equilibrium

Short-run equilibrium is where AD = SRAS. Long-run behaviour is where the schools differ.

Monetarist / new classical model. Long-run equilibrium is where AD = SRAS = LRAS, at full employment output. The economy adjusts automatically: in a recession, unemployment puts downward pressure on wages and other costs, SRAS shifts right, and output returns to Yf at a lower price level. In a boom, rising wages shift SRAS left until output is back at Yf with higher prices. At full employment, unemployment is not zero but equal to the natural rate of unemployment (structural + frictional + seasonal, 3.3).

AD meets SRAS1 at Y1, left of the vertical LRAS at Yf, a recession. As wages and costs fall, SRAS shifts right to SRAS2, which meets AD on the LRAS at Yf with a lower price level PL2.
Self-correction: falling costs shift SRAS until the economy is back at full employment.

Keynesian model. Because wages and prices do not fall easily, a recession can persist: the economy can be in equilibrium in section I of the AS curve, with a deflationary gap and high unemployment, for a long time. Pessimism can make it worse: falling incomes cut consumption, which cuts output further. Recovery needs AD to rise, so the government should intervene (demand management, 3.6).

A Keynesian AS curve. AD1 meets the horizontal section at Y1, well below full-employment output Yf, a persistent deflationary gap. A higher AD2 meets the rising section at Y2, closer to Yf, with a higher price level PL2.
In the horizontal range, higher AD raises output without raising prices.

Assumptions and implications of the two models

Monetarist / new classical
Assumes flexible wages and prices, rational agents and self-correcting markets. Implication: demand-side policy cannot raise output permanently, only the price level; governments should keep inflation low and stable and use supply-side policies to raise potential output. Intervention risks inflation and government failure.
Keynesian
Assumes sticky wages and prices, that expectations and confidence matter, and that markets can fail to clear for long periods. Implication: governments should actively manage AD, especially in recessions, through fiscal policy. “In the long run we are all dead”: waiting for self-correction is too costly.

Evidence supports parts of both: long recessions (the 1930s, Japan in the 1990s, the 2008–09 crisis) suggest slow self-correction, while 1970s stagflation and high inflation after large stimulus suggest limits to demand management.

✏️Worked example

For each event, state which curve shifts, in which direction, and the likely short-run effect on the price level and real GDP: (a) the central bank cuts interest rates; (b) world oil prices double; (c) a major trading partner enters recession; (d) a large investment in vocational training bears fruit years later.

(a) Lower borrowing costs raise C and I: AD shifts right. Price level ↑, real GDP ↑ (by how much depends on how close the economy is to full capacity).

(b) Higher costs for firms: SRAS shifts left. Price level ↑, real GDP ↓: cost-push inflation, possibly stagflation.

(c) Lower foreign incomes reduce demand for exports, so X falls: AD shifts left. Price level ↓ (or rises more slowly), real GDP ↓.

(d) Better-quality labour raises productive capacity: LRAS (Keynesian AS) shifts right. Potential output ↑, downward pressure on the price level.

Check it. Demand shocks move the price level and output in the same direction; supply shocks move them in opposite directions. Use this to check every AD/AS answer.
Mislabelling the axes. “Price” and “Quantity” on an AD/AS diagram lose the diagram marks. Use “Average price level” and “Real GDP” (or real output), and label Yf when full employment matters.

📝Practise

Tagged questions are modelled on a real IB question from that session, with our own wording and context.

1. [2 marks, Paper 2 style] Define the term aggregate demand.
The total planned spending on an economy’s final goods and services at each possible average price level in a given period: C + I + G + (X − M).
2. [10 marks, Paper 1 (a) — modelled on November 2023 SL Paper 1 Q2(a)] Explain, with an AD/AS diagram, how a wave of consumer optimism and a rise in the central bank’s policy rate would each affect real output in the short run.

Consumer confidence rises: households are more optimistic about jobs and income, so they spend more and save less: C rises, AD shifts right, and in the short run the price level and real GDP both rise (AD/AS diagram with SRAS).

Interest rates rise: borrowing becomes dearer and saving more rewarding, so credit-financed consumption and investment fall; mortgage payments rise, cutting disposable income: AD shifts left, price level and real GDP fall. If both happen together, the net effect depends on their relative strength. Two diagrams, clearly labelled.

3. [10 marks, Paper 1 (a) — modelled on November 2023 SL Paper 1 Q2(a)] Explain how new automation technology and a larger pool of trained technicians would affect an economy’s full employment output.
Potential output is the output the economy can produce when its resources are fully employed. Technology raises productivity (more output per worker and per machine), so the economy can produce more with the same resources. More skilled workers raise the quantity and quality of labour. Both shift LRAS right (Yf1 to Yf2), or the Keynesian AS right, and the PPC outward. Explain each with an LRAS diagram, noting lower inflationary pressure at any level of AD.
4. [10 marks, Paper 1 (a) — modelled on November 2024 HL Paper 1 Q2(a)] Using an AD/AS diagram, explain how, according to monetarist/new classical economists, an economy recovers from a recession without government action.
Start from long-run equilibrium at Yf (unemployment = natural rate). Show a fall in AD: short-run output falls to Y1, unemployment rises above the natural rate. With flexible wages, unemployed workers accept lower wages and input prices fall, so SRAS shifts right until it meets AD on the LRAS at Yf, at a lower price level. The reverse happens after a rise in AD (wages rise, SRAS shifts left). Because LRAS is vertical at Yf, the only long-run equilibrium has unemployment at the natural rate. Mention the assumptions (flexible prices, rational expectations).
5. Explain why the Keynesian AS curve is horizontal at low levels of real GDP.
At low output there is a large deflationary gap: many unemployed workers and idle machines. Firms can raise output by hiring idle resources without bidding up wages or input prices, and wages are sticky downwards, so the price level neither rises nor falls. Output can therefore increase with no change in the price level.
6. [4 marks, Paper 2 style] Using an AD/AS diagram, explain the likely effect on real GDP of a sharp rise in global energy prices for an energy-importing country.
Energy is an input for almost all firms, so costs of production rise: SRAS shifts left. At the original price level there is excess demand, so the price level rises (cost-push inflation) and real GDP falls as firms cut output. Diagram: AD, SRAS1, SRAS2, PL1 to PL2 up, Y1 to Y2 down. (Also: higher import bills reduce net exports, shifting AD left.)

🔗Go deeper — other people’s work

These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.

  • Khan Academy — Aggregate demand and aggregate supply unit.
  • Bank Indonesia — Monetary Policy Report, which discusses the drivers of Indonesian demand and inflation each quarter.
  • Marginal Revolution University — Principles of Macroeconomics videos on the AD/AS model.