The AD–AS idea in one picture (no heavy math)
The Aggregate Demand–Aggregate Supply (AD–AS) framework is a simple way to connect three things at once: total spending in the economy, the economy’s ability to produce, and the overall price level. It helps you answer questions like: “If households suddenly spend less, what happens to output and inflation?” or “If energy becomes more expensive, why can inflation rise even when growth slows?”
Think of the economy as a giant marketplace. Buyers bring planned spending; sellers bring goods and services. Prices adjust, and firms decide how much to produce given their costs and the prices they can charge.
1) Aggregate demand (AD): planned spending and what shifts it
What AD means (intuitively)
Aggregate demand is the total amount of spending that households, firms, government, and foreigners plan to make on domestically produced goods and services at different overall price levels. In the AD–AS diagram, AD is typically drawn as a downward-sloping curve: when the overall price level is higher, the same nominal income and money balances buy fewer goods and services, so planned spending tends to be lower.
A practical way to remember AD is the spending identity:
AD (planned spending) = C + I + G + NXWhere:
- Listen to the audio with the screen off.
- Earn a certificate upon completion.
- Over 5000 courses for you to explore!
Download the app
- C (Consumption): household spending on goods and services
- I (Investment): business spending on equipment, structures, and inventories (and often housing in simplified models)
- G (Government purchases): government spending on goods and services (not transfers)
- NX (Net exports): exports minus imports
How AD shifts: the “why did spending change?” checklist
AD shifts when planned spending changes at a given price level. Use this checklist to diagnose the direction:
| Component | What can push it up (AD shifts right) | What can push it down (AD shifts left) |
|---|---|---|
| Consumption (C) | Rising real incomes, stronger consumer confidence, easier credit, lower interest rates, rising household wealth | Falling confidence, tighter credit, higher interest rates, falling wealth, precautionary saving |
| Investment (I) | Lower borrowing costs, optimistic sales expectations, new technologies, tax incentives | Higher interest rates, uncertainty, weak sales outlook, tighter financial conditions |
| Government (G) | Higher public spending on goods/services | Spending cuts (austerity) |
| Net exports (NX) | Foreign growth, weaker domestic currency (exports cheaper, imports pricier) | Domestic boom raising imports, stronger domestic currency, foreign slowdown |
Step-by-step: diagnosing an AD shift from a news headline
- Step 1: Identify the spending channel. Is the story about households, firms, government, or trade?
- Step 2: Decide the direction for that component. For example, “confidence falls” usually lowers C; “rates rise” often lowers I and sometimes C.
- Step 3: Translate to AD. If a major component falls, AD shifts left; if it rises, AD shifts right.
- Step 4: Predict short-run effects using AD–AS. With SRAS unchanged, a left shift tends to lower output and inflation; a right shift tends to raise both.
2) Short-run aggregate supply (SRAS): production, costs, and expectations
What SRAS means (intuitively)
Short-run aggregate supply describes how much firms are willing to produce at different overall price levels given current costs and expectations. In the short run, many costs (especially wages and some input contracts) don’t adjust instantly. Because of that, when the overall price level rises while key costs are temporarily “sticky,” producing becomes more profitable, and firms supply more. That’s why SRAS is usually upward sloping.
What shifts SRAS: the “cost and pricing” checklist
SRAS shifts when firms’ costs or pricing conditions change, even if demand is unchanged.
| SRAS shifter | What happens | Typical SRAS shift |
|---|---|---|
| Input costs (energy, materials, imported inputs) | Higher costs squeeze margins at any given price level | Left (less supply) |
| Wages and labor costs | Higher wages not matched by productivity raise unit costs | Left |
| Productivity | Higher productivity lowers unit costs | Right (more supply) |
| Supply chain disruptions | Delays and shortages raise effective costs and reduce capacity | Left |
| Inflation expectations | If workers/firms expect higher inflation, they set higher wages/prices now | Often left (higher costs at each output level) |
Sticky wages and expectations: why SRAS can move without “demand” changing
Two mechanisms are especially important:
- Wage-setting: If workers negotiate higher wages (or firms must pay more to hire), firms’ costs rise. If firms can’t fully pass those costs into prices immediately, they cut production or hiring.
- Price-setting and expectations: If firms expect higher overall inflation, they may raise prices more aggressively to protect margins. If workers expect higher inflation, they may demand higher wages. These expectations can shift SRAS left even before any actual shortage appears.
3) Demand shocks vs supply shocks: different fingerprints on output and inflation
In AD–AS, a “shock” is a sudden change that shifts AD or SRAS. The key skill is recognizing the pattern:
Demand shock (AD shifts, SRAS unchanged)
- Positive demand shock (AD right): output rises, inflation rises.
- Negative demand shock (AD left): output falls, inflation falls.
Demand shocks tend to move output and inflation in the same direction.
Supply shock (SRAS shifts, AD unchanged)
- Negative supply shock (SRAS left): output falls, inflation rises.
- Positive supply shock (SRAS right): output rises, inflation falls.
Supply shocks tend to move output and inflation in opposite directions.
A quick “fingerprint” table
| Shock type | Curve shift | Output (short run) | Inflation (short run) | Common examples |
|---|---|---|---|---|
| Demand ↑ | AD → right | ↑ | ↑ | Credit boom, fiscal expansion, surge in confidence |
| Demand ↓ | AD → left | ↓ | ↓ | Confidence drop, tighter financial conditions, foreign recession reducing exports |
| Supply ↓ | SRAS → left | ↓ | ↑ | Oil spike, supply chain disruption, wage-cost surge |
| Supply ↑ | SRAS → right | ↑ | ↓ | Productivity gains, input cost declines, logistics improvements |
4) Interpreting real scenarios with AD–AS
Scenario A: an oil price spike
Story: Energy is a key input for transportation, manufacturing, and many services. When oil prices jump, firms’ costs rise quickly.
Step-by-step using AD–AS:
- Step 1: Identify the primary channel. Higher oil prices raise production costs across many industries.
- Step 2: Decide which curve shifts. This is mainly a negative supply shock → SRAS shifts left.
- Step 3: Predict output and inflation. Output tends to fall while inflation tends to rise (stagflation-like pattern).
- Step 4: Consider second-round effects. If workers demand higher wages to keep up with higher living costs, wage growth can increase firms’ costs further, reinforcing the left shift in SRAS. If consumers cut discretionary spending because gasoline is more expensive, AD may also drift left, deepening the output slowdown.
What you might see in data: rising transportation and goods prices, squeezed profit margins, slower hiring, and weaker output growth.
Scenario B: a sudden drop in consumer confidence
Story: Households become worried about job security or future income and decide to postpone big purchases.
Step-by-step using AD–AS:
- Step 1: Identify the primary channel. Lower confidence reduces consumption (C).
- Step 2: Decide which curve shifts. This is a negative demand shock → AD shifts left.
- Step 3: Predict output and inflation. Output tends to fall and inflation tends to fall (or disinflation increases).
- Step 4: Add amplification mechanisms. Firms see weaker sales, cut investment (I), and reduce hiring; that can further reduce incomes and spending, pushing AD left again.
What you might see in data: falling retail sales, weaker services demand, slower price increases, and rising layoffs in consumer-facing sectors.
Scenario C: both shocks at once (why the diagnosis matters)
Sometimes the economy gets hit by multiple forces. For example, an oil spike (SRAS left) plus falling confidence (AD left) can produce lower output with an ambiguous inflation outcome (one shock pushes inflation up, the other pushes it down). In that case, the AD–AS framework helps you separate the forces rather than treating inflation or growth as coming from a single cause.
5) Policy choices and short-run tradeoffs in the AD–AS framework
AD–AS is often used to think about stabilization policy: what governments and central banks can do to reduce large swings in output and inflation in the short run.
Demand management: moving AD
When the problem is mainly a demand shock, policies that influence spending can be more straightforward:
- If AD falls (recessionary demand shock): policymakers may try to push AD right by lowering interest rates (to support C and I) or increasing government purchases (G). The goal is to raise output and prevent inflation from falling too much.
- If AD rises too fast (overheating): policymakers may try to pull AD left by raising interest rates or reducing government purchases growth. The goal is to reduce inflation pressure, accepting slower output growth.
Supply shocks: the uncomfortable tradeoff
Supply shocks create the classic short-run dilemma: inflation rises while output falls. In AD–AS terms, SRAS shifts left, and there is no single AD move that fixes both problems at once.
- Option 1: Fight inflation aggressively (pull AD left). This can reduce inflation but may further lower output in the short run.
- Option 2: Support output (push AD right). This can cushion the output drop but may worsen inflation.
- Option 3: Improve supply conditions directly. Policies that reduce bottlenecks, improve productivity, or lower key input costs can shift SRAS right, easing inflation while supporting output—but these often take time or face constraints.
Step-by-step: choosing a policy response based on the shock
- Step 1: Use the “fingerprint.” Are output and inflation moving together (demand) or opposite (supply)?
- Step 2: Identify the main constraint. Is inflation already high? Is output already weak? Are expectations becoming unanchored?
- Step 3: Pick the primary lever. Demand tools (interest rates, government purchases) mainly shift AD; structural and cost-related measures mainly affect SRAS over time.
- Step 4: Communicate expectations. Because expectations can shift SRAS, credible policy communication can reduce the risk of a wage–price spiral after a supply shock.
Used this way, AD–AS is less about drawing perfect curves and more about building a disciplined habit: name the shock, identify the curve shift, predict the direction of output and inflation, then evaluate the policy tradeoff.
