Aggregate Demand & Aggregate Supply
Output and the price level in a single diagram. The short-run vs long-run conversation, made visible.
Built and reviewed by Stephen Omukoko Okoth
Mathematical Economist · ex-Morgan Stanley FI · Equilar
Theory
What the model says, and why
AD-AS solves for output Y and the price level P jointly. The aggregate demand curve traces combinations of (Y, P) at which the goods market clears; the short-run aggregate supply curve traces what producers are willing to supply at each price given fixed expectations and sticky wages. Long-run aggregate supply is vertical at potential output Yₙ.
AD slopes downward because higher prices erode real balances and real wealth, depressing demand. The multiplier and the wealth effect together determine its slope.
SRAS slopes upward: producers will only supply above potential when prices exceed expectations. As expectations adjust (Pᵉ rises), SRAS shifts up — the economy moves back to Yₙ. That convergence is what makes LRAS vertical.
What the model is for. It separates demand-side and supply-side disturbances. Demand shocks (shifts in A) move output and prices in the same direction; supply shocks (shifts in α or Pᵉ) move them in opposite directions — the textbook stagflation diagnosis.
Interactive playground
Move the parameters, watch the equilibrium move
Parameters
Demand side
Supply side
Equilibrium
Y* = 1644, P* = 606.3
Output Y*
1644
Price level P*
606.3
Potential Yₙ
800
LRAS
Inflationary gap
+844
LRAS sits at Y = 800 (vertical, not drawn).
In the classroom
How to teach it well
Demand shock walkthrough. Increase A. AD shifts right. Output and price both rise — the inflationary gap grows. In the long run, expectations adjust upward (Pᵉ rises), SRAS shifts left, output returns to Yₙ, prices end up higher. Movement along, then movement of, the supply curve.
Supply shock walkthrough. Lower α (sticky prices) or raise Pᵉ (expectations of higher inflation). SRAS shifts left. Output falls, prices rise — stagflation. Demand-side policy can't fix this without sacrificing one variable to save the other.
Why the long run is vertical. If output sits above Yₙ, expectations keep ratcheting up, shifting SRAS until equilibrium output equals potential. The only thing changing is the price level. This is the classical neutrality-of-money result, dressed in Keynesian clothes.
Compare with IS-LM. IS-LM holds prices fixed and solves the goods + money markets. AD-AS relaxes the fixed-price assumption — AD itself is derived from IS-LM at varying P. Use the two together: IS-LM for short-run interest-rate logic, AD-AS for the inflation conversation.