Variations in economic activity: aggregate demand and aggregate supply

The total spending on goods and services in an economy at a given price level over a period of time. AD = C + I + G + (X − M). It shows the relationship between the general price level and real GDP demanded.

Not labelling axes correctly (GPL on y-axis, real GDP on x-axis). Drawing it as a straight line instead of a curve. Forgetting to label the curve "AD". Not showing clear shift direction with arrows when drawing shifts.

Higher consumer confidence, lower interest rates, increased government spending, tax cuts, depreciation of the currency (boosts exports), or increased wealth. Any factor that increases C, I, G, or (X − M).

Lower consumer confidence, higher interest rates, decreased government spending, tax increases, appreciation of the currency (hurts exports), or a fall in wealth. Any factor that decreases C, I, G, or (X − M).

Three reasons: (1) Wealth effect — higher prices reduce the real value of savings, so spending falls. (2) Interest rate effect — higher prices increase demand for money, pushing up interest rates, reducing investment and consumption. (3) Net export effect — higher prices make exports dearer and imports cheaper.

Vertical axis: "Average price level" or "GPL". Horizontal axis: "Real GDP" or "Real output". Label each curve (AD, SRAS, LRAS). Use AD₁, AD₂ for shifts. Mark equilibrium points. Include arrows showing shift direction.

C (consumption/consumer spending), I (investment by firms), G (government spending on goods and services), and (X − M) net exports. A change in any component shifts the AD curve.

Lower interest rates reduce borrowing costs → consumers spend more (especially on housing/cars) and firms invest more → AD shifts right. Higher rates have the opposite effect → AD shifts left.

The AD curve shifts to the right (from AD₁ to AD₂). This means at every price level, more real GDP is demanded. The new equilibrium has higher real GDP (and typically a higher price level unless the economy has spare capacity).

A movement along AD occurs when the price level changes (a change in quantity demanded). A shift of AD occurs when a non-price factor changes (e.g., consumer confidence, interest rates, government spending), moving the entire curve left or right.

A large AD shift has a bigger impact on output and prices than a small shift. In IB essays, you should discuss whether the shift is likely to be large or small, and what this means for the extent of change in GDP and inflation.

A depreciation makes exports cheaper and imports dearer → (X − M) rises → AD shifts right. An appreciation makes exports dearer and imports cheaper → (X − M) falls → AD shifts left.

Consumption (C) is the largest component of AD (50–70%). When consumers feel optimistic about jobs and income, they spend more; when pessimistic, they save more. Small changes in confidence can shift AD significantly.

The vertical axis shows the general/average price level (GPL). The horizontal axis shows real GDP (real output). The AD curve slopes downwards from left to right.

On a flat SRAS (spare capacity): AD shift increases output with little inflation. On a steep SRAS (near capacity): AD shift mainly raises prices with little extra output. The AS shape determines the trade-off.

The maximum sustainable output an economy can produce when all resources are fully and efficiently employed. In the Monetarist/New Classical model, LRAS is a vertical line at the full-employment level of output (Yf).

SRAS: at least some input prices (especially wages) are fixed/sticky. LRAS: all input prices have fully adjusted. This is what determines whether the curve slopes upward (SRAS) or is vertical (LRAS).

The total output that firms in an economy are willing and able to produce at each price level in the short run, when at least some input prices (especially wages) are fixed. The SRAS curve slopes upwards.

As the price level rises, firms' revenues increase but input costs (especially wages) are sticky in the short run. This means profit margins widen, incentivising firms to produce more output. Higher prices → more production.

The short run is the period during which at least some input prices (especially wages) have not yet adjusted to changes in the price level. This could be months or a few years, depending on the economy and the rigidity of contracts.

In the long run, all input prices adjust fully to changes in the price level. Since real wages and real costs return to equilibrium, the economy's output depends only on real factors (technology, resources, institutions), not the price level.

SRAS shifts: changes in costs of production (wages, oil, taxes, exchange rate). LRAS shifts: changes in the quality/quantity of factors of production (technology, education, capital stock, labour force, institutional reform).

Changes in costs of production: wages, raw material prices (e.g., oil), indirect taxes/subsidies, exchange rate changes affecting import costs, productivity changes. Rising costs shift SRAS left; falling costs shift it right.

Increases in the quantity or quality of resources: more/better labour (education, immigration), more capital (investment), technological progress, institutional improvements, discovery of natural resources. These increase the economy's productive capacity.

The Keynesian LRAS has three sections: (1) flat — spare capacity, output can rise without inflation; (2) upward-sloping — approaching capacity, some inflation; (3) vertical — at full capacity, more spending only causes inflation.

Oil is a key input for transport, manufacturing, and energy. Higher oil prices raise production costs across the economy, shifting SRAS left. This causes cost-push inflation (higher prices) and lower output — stagflation.

Yes. For example, a major investment in technology reduces costs in the short run (SRAS shifts right) and increases productive capacity in the long run (LRAS shifts right). Not all events affect both, but some do.

LRAS shift right: increases potential output, often lowers the price level — represents genuine growth in productive capacity. AD shift right: increases demand, which may raise both output and prices. LRAS shifts are supply-side driven; AD shifts are demand-side driven.

A movement along SRAS is caused by a change in the price level. A shift of SRAS is caused by a change in production costs (wages, materials, taxes) independent of the price level.

SRAS shocks (e.g., oil) cause short-run pain but may self-correct. LRAS shifts determine long-run prosperity. Demand management affects SRAS outcomes; supply-side policies target LRAS. Using the wrong policy wastes resources.

AD shifts right when the economy is near capacity → the price level rises significantly but output increases only slightly. The excess demand "pulls" prices up. Shown as AD moving right along a steep section of SRAS.

At the intersection of the AD and SRAS curves. This determines the equilibrium price level and equilibrium real GDP in the short run. The economy can be in equilibrium above, below, or at full employment.

The economy self-corrects: if AD increases beyond full employment, wages and costs eventually rise, shifting SRAS left until output returns to Yf. The price level is permanently higher, but output returns to potential. No government intervention is needed.

SRAS shifts left due to rising production costs (oil, wages, taxes) → the price level rises and output falls simultaneously (stagflation). Rising costs "push" prices up regardless of demand.

Yes. If AD is weak, the AD-SRAS intersection can be to the left of LRAS, meaning there is a deflationary gap with unemployed resources. Short-run equilibrium does not imply full employment.

Keynesians argue the economy does NOT automatically self-correct in a reasonable timeframe. With sticky wages and prices, a recession can persist for years. Government intervention (fiscal/monetary policy) is needed to restore full employment.

With output below Yf, unemployment is high → workers accept lower wages → production costs fall → SRAS shifts right → output gradually returns to Yf at a lower price level. This process can be slow and painful.

AD shifts right → new intersection with SRAS is at higher real GDP and higher price level. Output rises, unemployment falls, but some inflation occurs. The effect depends on where the economy starts relative to capacity.

Demand-pull: contractionary policy (raise rates, cut spending) can reduce AD and inflation. Cost-push: contractionary policy reduces AD but worsens the recession. Supply-side policies are needed to shift SRAS back right — a much harder cure.

The 1973 and 1979 oil crises: OPEC restricted oil supply → oil prices quadrupled → production costs soared across all sectors → SRAS shifted left → stagflation in most Western economies (high inflation + high unemployment + low growth).

SRAS shifts left → new equilibrium has lower real GDP and higher price level. This is stagflation — simultaneous inflation and falling output. It is particularly problematic because stimulating AD would worsen inflation.

New Classicals say adjustment is relatively fast (flexible markets). Keynesians say it is slow (sticky wages, pessimistic expectations, liquidity traps). The speed determines how much governments should intervene and for how long.

Supply-side policies shift LRAS right, increasing potential output and reducing the natural rate of unemployment. They complement demand management by ensuring long-run growth, not just short-run stabilisation.

If actual output exceeds potential (inflationary gap), workers demand higher wages, input costs rise, SRAS shifts left. This continues until output returns to the full-employment level (LRAS), but at a higher price level.

Yes. For example, a pandemic can shift AD left (less consumer spending) and SRAS left (supply chain disruptions). This makes the recession deeper while the price effect is ambiguous. COVID-19 was a textbook dual shock.