Key Idea: Prices in the shops rise, a factory cuts a shift, the news says the economy is slowing. To explain any of that, economists shrink the whole country onto one diagram: how much everyone plans to spend at each price level, and how much firms can produce. Aggregate demand is the spending side. Aggregate supply is the production side, in the short run (costs fixed) and in the long run (capacity). Where they cross is the price level and real GDP of the whole economy. How far that crossing sits from full employment is the difference between a boom and a recession. Where you meet it:
Paper 1
- Essays.
- Explain [10]: two determinants of consumption or investment; why a deflationary gap can persist in the Keynesian model.
Paper 2
- Data response.
- Define [2]: investment.
- Sketch [2] an AD shift; Explain [4] with a diagram: exports, energy prices, potential output. The commonest question in this topic.
The diagram
- Three curves, one crossing.
- AD, SRAS, LRAS: price level up the side, real GDP along the bottom, Yf marked. Shift one curve, read the new crossing.
🛒 Aggregate demand: everything the economy plans to buy
Aggregate demand (AD) is the total planned spending on a country's goods and services at each price level: AD = C + I + G + (X − M). It is the demand curve for the whole economy, so the axes change: the price level goes up the side and real GDP along the bottom. AD slopes down: at a lower price level savings buy more, interest rates fall, and exports sell better abroad.
| Component | What it is | What makes it rise |
|---|---|---|
| C, consumption | household spending on goods and services: the largest part, about 60–70% of AD | more confidence, lower interest rates, tax cuts, higher wealth from house or share prices |
| I, investment | firms' spending on capital goods: factories, machines, software | business optimism, lower interest rates, new technology, tax incentives |
| G, government spending | public spending on goods and services, not pensions or benefits | a government choosing to spend more: expansionary fiscal policy |
| (X − M), net exports | exports minus imports | a weaker exchange rate, growth in trading partners, trade agreements |
A change in the price level is a movement along AD. Anything else that changes spending shifts the whole curve: name the component (C, I, G or X − M) and say why it moved. A fall in any component shifts AD left: falling confidence, higher interest rates, higher taxes, a stronger exchange rate, a recession abroad.
🏭 Short-run aggregate supply: output while costs are fixed
SRAS is the total output firms are willing to supply at each price level while at least one cost, usually wages, is fixed. It slopes up: a higher price level with fixed costs means more profit per unit, so firms produce more. SRAS moves only when the costs of production change.
SRAS shifts left (costs rise): Wages, raw materials or energy become more expensive.. An indirect tax is raised.. A supply shock: a drought, an earthquake, a pandemic that closes factories.. The currency depreciates, so imported inputs cost more..
SRAS shifts right (costs fall): Wages or energy prices fall.. A subsidy to producers lowers their costs.. A good harvest, or a new technology that cuts costs.. The currency appreciates, so imported inputs cost less..
Ask: did the cost of making things change? If yes, SRAS moves. Higher costs → SRAS left → a higher price level and lower real GDP at the same time. More workers, better machines or better schooling are not costs: they change capacity, so they move LRAS instead.
🏗️ Long-run aggregate supply: two views of what the economy can make
LRAS is the most an economy can produce when all its resources are fully employed: potential GDP, or full-employment output, Yf. Economists draw it in two ways. Both are accepted if you say which one you are using and stay with it.
| Point | New classical (monetarist) | Keynesian |
|---|---|---|
| Shape | a vertical line at Yf: in the long run output does not depend on the price level | horizontal while there is spare capacity, curving up as capacity fills, vertical at Yf |
| A rise in AD | in the long run only the price level rises; output returns to Yf | with spare capacity, output rises and the price level barely moves; near Yf, prices rise more |
| A fall in AD | wages fall, SRAS shifts right, the economy returns to Yf by itself | wages are sticky downward, so the economy can stay below Yf for years |
| What shifts it | capacity: more or better workers, capital, technology, education, institutions | the same: LRAS moves only when the quantity or quality of factors of production changes |
Important: A rise in wages shifts SRAS left. A better-trained workforce shifts LRAS right. Mixing the two gives the opposite answer. LRAS shifts left only rarely: a war that destroys capital, a natural disaster, or workers emigrating.
⚖️ Equilibrium and the gaps
The economy settles where AD crosses SRAS: that crossing fixes the price level and real GDP together. If it also sits on LRAS, the economy is at full employment. If not, there is an output gap: a distance on the diagram between real GDP and Yf.
| Where AD meets SRAS | Name | What it means |
|---|---|---|
| Left of LRAS | deflationary (recessionary) gap | real GDP below Yf: spare capacity, cyclical unemployment above the natural rate |
| On LRAS | long-run equilibrium | real GDP = Yf: full employment, no gap |
| Right of LRAS | inflationary gap | real GDP above Yf: firms work beyond what they can sustain, so the price level is pulled up |
A gap is a distance. Draw LRAS, label Yf on the axis, then show the equilibrium output beside it. Without Yf no one can see the gap. In the explorer above, shift AD, then SRAS, one curve at a time, and read the new crossing each time.
💥 Shocks: which curve moved, and what happens next
A demand shock shifts AD, so the price level and real GDP move the same way. A supply shock shifts SRAS, so they move in opposite directions. Then the question is whether the economy fixes itself. The new classical view says yes; follow the steps after a fall in AD.
Self-correction after AD falls (new classical view)
- AD shifts left — Spending falls: an export slump, a fall in confidence. Real GDP drops below Yf. A deflationary gap opens and unemployment rises.
- Wages fall — With more people looking for work, wages eventually fall. Firms' costs of production fall with them.
- SRAS shifts right — Lower costs mean firms supply more at each price level. SRAS moves right until it crosses AD on LRAS.
- Back at Yf, lower prices — Full employment again, at a lower price level, with no help from the government. After a rise in AD the steps run the other way: wages rise, SRAS shifts left, output returns to Yf at a higher price level.
AD falls → gap → wages fall → SRAS right → back to Yf
Important: Workers resist pay cuts and minimum wages stop wages falling. If wages are sticky downward, SRAS does not shift right and the economy can stay in a deflationary gap for years. That is the case for the government spending more or cutting interest rates rather than waiting. Stagflation: SRAS shifts left, so inflation rises and real GDP falls at the same time. Fighting one makes the other worse.
✍️ Worked examples
The four shapes this topic is asked in, with new scenarios. Try each before opening the plan.
A text describes car makers postponing orders for new robots because their sales are falling. Define the term investment.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Now the Sketch.
A country's largest trading partner goes into recession and demand for the country's exports falls sharply. Sketch an AD/AS diagram showing the effect on the country's real GDP.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Animated graph
Watch the graph build step by step in study mode.
Now the diagram question on the supply side.
A government completes a nationwide high-speed broadband network that connects every business and school. Using an AD/AS diagram, explain the effect on the country's potential output.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
And the Paper 1 shape.
Explain two determinants of investment that could cause investment to fall, and the effect on real GDP.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
✅ Quick self-check
Tap each card to check yourself.
Write out the AD equation and say what each letter stands for. AD = C + I + G + (X − M): consumption by households, investment by firms, government spending on goods and services, and net exports (exports minus imports).
The price level falls. Give the three reasons total spending rises. Savings and money buy more (wealth effect); interest rates fall so C and I rise (interest rate effect); exports become cheaper abroad and imports less attractive (trade effect).
Energy prices double. Which curve moves, which way, and what happens to prices and output? SRAS shifts left: energy is a cost of production. The price level rises and real GDP falls at the same time: stagflation.
The government opens new universities. SRAS or LRAS? LRAS, to the right. Better education raises the quality of the workforce: that is capacity, not a cost of production.
Real GDP is below Yf. What is the gap called, and who feels it? A deflationary (recessionary) gap. There is spare capacity and cyclical unemployment: people who would work at current wages cannot find a job.
Real GDP is above Yf. Is that possible, and what is it called? Yes, for a while: firms run overtime and extra shifts. It is an inflationary gap: demand is more than the economy can sustain, so the price level is pulled up.
In the new classical view, what happens in the long run after AD rises? Higher prices → workers demand higher wages → costs rise → SRAS shifts left → output returns to Yf at a higher price level. In the long run more AD only means more inflation.
Why can a deflationary gap last for years in the Keynesian model? Wages are sticky downward: workers resist cuts and minimum wages stop falls. SRAS does not shift right, so output stays below Yf until something lifts AD.
Exam tips
- Axes: price level and real GDP. Price and quantity are the axes of a single market; here they describe a different diagram.
- Name the component that moved and why. AD falls because exports fall explains; AD falls only describes.
- Costs of production shift SRAS. Factors of production shift LRAS. Decide which before you draw.
- Demand shocks move the price level and real GDP the same way; supply shocks move them opposite ways.
- Draw LRAS and label Yf. A gap is a distance, and without Yf there is nothing to measure it from.
- Say which AS model you are drawing, new classical or Keynesian, and keep it for the whole answer.
- For an Explain [4] with a diagram: the shift, the new equilibrium labelled, one sentence of chain, one sentence of result.