ECON5002 · Macroeconomic Theory
The Aggregate Supply-Aggregate Demand Model
The AD-AS model is the single diagram that ties the whole economy together: a downward aggregate demand curve and an upward short-run aggregate supply curve fix the price level and real output, while a vertical long-run aggregate supply at natural output Yₙ pins down where the economy must settle once wages and prices adjust. ECON5002 teaches a distinctive version — AD slopes down mainly because the central bank raises the interest rate when prices rise above target (the textbook real-balance/Keynes effect is switched off under endogenous money), and SAS is built from a price-cost mark-up with diminishing returns rather than just sticky wages. This is the first topic on the final exam, where demand shocks move you along SAS, cost shocks shift SAS itself, and stagflation is the result no demand policy can cheaply cure.
What this chapter covers
- 011. The AD-AS frame — price level P on the vertical axis, real output Y on the horizontal
- 022. Why AD slopes down — the monetary-policy reaction effect (dominant), wealth effect (weak), international-competitiveness effect
- 033. The interest-rate rule i = iₙ + a(P − Pᵀ) and why the Keynes effect is switched off under endogenous money
- 044. What shifts AD — fiscal, monetary-rule changes, autonomous spending and exchange-rate shocks
- 055. Short-run AS from the price-cost mark-up and diminishing returns to variable inputs
- 066. Long-run AS vertical at natural output Yₙ, the natural rate of unemployment, and money neutrality
- 077. Self-correction via wage/price flexibility vs the Keynesian downward-rigidity critique
- 088. Demand and supply shocks, stagflation, and long-run crowding out through the policy rule
Solving AD-AS algebraically and tracing a supply shock
- +1Set AD = SAS for the initial equilibrium: 900 − 20P = 300 + 40P.
- +2Solve: 600 = 60P, so P* = 10. Back-substitute: Y* = 900 − 20(10) = 700 (check SAS: 300 + 40(10) = 700).
- +1Since Y* = 700 = Yₙ, the economy starts at natural output — it sits on LAS as well as on AD and SAS, so this is a full long-run equilibrium.
- +1Apply the shock: set the new SAS equal to AD, 900 − 20P = 120 + 40P.
- +2Solve: 780 = 60P, so P′ = 13. Back-substitute: Y′ = 900 − 20(13) = 640 (check: 120 + 40(13) = 640).
- +1Classify: the price level rose from 10 to 13 while output fell from 700 to 640, now below Yₙ — this is stagflation (higher prices with lower output).
Key terms
- Aggregate demand (AD) curve
- The downward-sloping locus of price-level and real-output combinations consistent with goods- and money-market equilibrium, derived from IS-LM. It slopes down chiefly because the central bank raises the interest rate when the price level exceeds its target.
- Monetary-policy reaction effect
- The dominant reason AD slopes down in this course: under the rule i = iₙ + a(P − Pᵀ), a higher price level prompts the bank to raise the interest rate, cutting interest-sensitive consumption and investment and so lowering output.
- Endogenous money
- The assumption that the money stock adjusts to demand at the policy-set interest rate, which is why the textbook Keynes/real-balance effect (a fixed real money supply shrinking as P rises) does not operate here.
- Short-run aggregate supply (SAS)
- The upward-sloping supply curve in (P, Y) space, built from a price-cost mark-up: with capital fixed, diminishing returns to variable inputs raise unit costs as output expands, so firms charge higher prices.
- Long-run aggregate supply (LAS)
- The vertical aggregate supply curve at natural output Yₙ. Once wages and prices fully adjust, output returns to Yₙ regardless of demand, so demand policy cannot permanently change real output.
- Natural output / natural rate (Yₙ, uₙ)
- The full-employment level of output and the corresponding unemployment rate (frictional plus structural). Yₙ shifts only with supply-side or structural change, never with demand management or a real-wage cut.
- Supply shock and stagflation
- A rise in an input cost (such as wages W or material prices V) shifts SAS left, raising the price level while lowering output — stagflation. Demand policy cannot cure it cheaply.
- Money neutrality
- The long-run result that monetary policy affects only nominal variables (the price level), not real output or employment, because the economy returns to Yₙ on the vertical LAS.
The Aggregate Supply-Aggregate Demand Model FAQ
Why does the AD curve slope downward in ECON5002?
Mainly because of the monetary-policy reaction effect: when the price level rises above target, the central bank raises the interest rate (i = iₙ + a(P − Pᵀ)), which cuts interest-sensitive consumption and investment and lowers output. The international-competitiveness effect reinforces this, while the wealth (Pigou) effect is weak. Crucially, the textbook real-balance/Keynes effect is switched off here because money is endogenous.
What is the difference between SAS and LAS?
Short-run aggregate supply slopes upward because capital is fixed and diminishing returns raise unit costs as output expands, so higher output comes with a higher price level. Long-run aggregate supply is vertical at natural output Yₙ: once wages and prices adjust, output returns to Yₙ no matter what the price level is.
Why does a cost shock cause stagflation?
An input-cost rise (higher wages or material prices) shifts SAS to the left, so the same demand now meets a higher price level at a lower output — prices up, output down. Demand management cannot fix both at once, which is why supply shocks are so painful.
What is the difference between a movement along SAS and a shift of SAS?
A demand-driven change in the price level moves you along a fixed SAS. A change in an input cost, in technology, or in the expected price level Pᵉ shifts the whole SAS curve. Misclassifying a cost shock as a movement along the curve is the most common SAS mistake.
How does the economy return to natural output after a demand shock?
Through wage/price flexibility: if output falls below Yₙ, labour-market slack pushes money wages and the expected price level down, which shifts SAS right and lowers the price level; the bank then lowers the interest rate and demand recovers until output is back at Yₙ. The Keynesian critique is that wages may be rigid downward, leaving the economy stuck below Yₙ.
Is this guide official or affiliated with the University of Sydney?
No. This is an independent AskSia study resource to help students revise. It is not produced, endorsed by, or affiliated with the University of Sydney. Always check Canvas and your unit outline for current dates, weights and rules.
Exam move
Make the whole AD-AS diagram drawable from memory, because the final exam expects labelled, correctly-shifted figures and rewards them more than prose. Learn the three reasons AD slopes down in the right order — lead with the monetary-policy reaction effect and explicitly note that the Keynes/real-balance effect is switched off under endogenous money, since that signals you learned the lecturer's version. Drill the curve-shifting logic until it is automatic: demand-side shocks (fiscal, autonomous spending, the exchange rate) move AD, while cost, technology and expected-price changes shift SAS, and only supply-side/structural change moves the vertical LAS at Yₙ. Practise solving AD = SAS algebraically for P and Y and then re-solving after a shock, and rehearse the three set-piece results — self-correction through wage flexibility versus the Keynesian rigidity case, stagflation from a supply shock, and long-run crowding out driven by the bank defending its price target.
