Key Idea: Topic 3.2 introduces the AD/AS model — the most important diagram in macroeconomics. It shows how the price level and real GDP are determined, and how shocks affect the economy.
✅ Core definitions
- Aggregate demand (AD)
- Total spending in the economy: AD = C + I + G + (X − M). Slopes downward.
- SRAS
- Short-run aggregate supply — upward-sloping. Shifts with input costs, supply shocks.
- LRAS
- Long-run aggregate supply — vertical (new classical) at potential output. Shifts with productive capacity.
📉 Why AD slopes downward
- Wealth effect — higher prices reduce real value of savings → C↓
- Interest rate effect — higher prices → higher rates → I↓ and C↓
- Trade effect — higher domestic prices → exports↓, imports↑ → (X−M)↓
🔄 What shifts AD?
- AD right — consumer/business confidence↑, lower interest rates, government spending↑, weaker exchange rate, tax cuts
- AD left — austerity, higher interest rates, stronger currency, falling confidence
📊 SRAS vs LRAS
SRAS: Upward-sloping. Shifts with **input costs** (wages, oil). Taxes, subsidies, supply shocks. Short-run price adjustments.
LRAS: Vertical at potential output. Shifts with **productive capacity**. Technology, labour force, capital. Long-run growth.
AD shifts affect actual output (short run). LRAS shifts affect potential output (long run). Know which diagram to draw for each policy.
⚡ Equilibrium and shocks
- Demand-pull — AD shifts right → price level↑ and real GDP↑ (inflationary pressure)
- Cost-push — SRAS shifts left → price level↑ and real GDP↓ (stagflation)
- Positive supply shock — SRAS shifts right → price level↓ and real GDP↑ (best outcome)