BEO6600 · Business Economics
Aggregate Demand and Supply
The AD-AS model is the single framework for whole-economy fluctuations, with the price level on the vertical axis and real output on the horizontal. Aggregate demand (AD) slopes downward for three reasons a lower price level raises spending — the wealth effect (on C), the interest-rate effect (on I, the most important channel for Australia) and the exchange-rate effect (on NX). Short-run aggregate supply (SRAS) slopes up because of sticky wages, sticky prices or misperceptions, so output deviates from the natural level only when the actual price level differs from the expected one. Long-run aggregate supply (LRAS) is vertical at the natural (potential) level of output, set by real resources. Shocks move the economy in the short run, then it self-corrects back to potential: a demand fall causes a recession that slowly reverses at a lower price level, while an adverse supply shock causes stagflation (output down and prices up at once). This is group-report scope, not the closed-book exam.
What this chapter covers
- 0110.1 Short-run fluctuations and the business cycle
- 0210.2 Why aggregate demand slopes downward (wealth, interest-rate, exchange-rate)
- 03The interest-rate effect leads for Australia
- 04Movement along AD vs a shift of AD
- 0510.3 Short-run aggregate supply (sticky wages, sticky prices, misperceptions)
- 0610.4 Long-run aggregate supply: vertical at natural output
- 0710.5 A demand-side recession and self-correction
- 0810.6 An adverse supply shock and stagflation
Worked example: tracing a recession and a supply shock
- +1(a) Short run: AD shifts left along a fixed SRAS, cutting both output and the price level. Output drops below the natural level — a recession, with rising unemployment.
- +1Adjustment: with output below potential and high unemployment, wages and input prices eventually fall, lowering costs and pushing SRAS right.
- +1Long run: SRAS keeps shifting right until output returns to the natural level on LRAS — at a permanently lower price level. A demand shift changes only the price level in the long run; this slow self-correction is the mechanism.
- +1(b) The cost spike shifts SRAS left (AD has not moved). Output falls while the price level rises at the same time.
- +1This combination is stagflation — stagnation plus inflation. There is no single AD move that fixes both: do nothing and let it self-correct (slow and painful), or accommodate with higher AD and push prices even higher.
Key terms
- Aggregate demand (AD)
- The total quantity of goods and services households, firms, government and foreigners want to buy at each price level, built on Y = C + I + G + NX. It slopes downward because a lower price level raises spending through three effects — wealth (C), interest-rate (I) and exchange-rate (NX); for Australia the interest-rate effect leads.
- Short-run aggregate supply (SRAS)
- An upward-sloping curve: in the short run a higher price level leads firms to produce more, because of sticky wages, sticky prices or misperceptions. Output deviates from the natural level only when the actual price level differs from the expected one, which is why the deviation is temporary.
- Long-run aggregate supply (LRAS)
- A vertical curve at the natural (potential, full-employment) level of output. In the long run wages and prices are fully flexible, so output is set by the economy's real resources, not the price level — doubling all prices doubles all wages and leaves real production unchanged.
- Self-correction
- The economy's tendency to return to potential output after a demand shock without policy. Following a recession, persistent unemployment slowly drags wages and input prices down, shifting SRAS right until output is back on LRAS — at a new price level. The mechanism works but can be slow and painful.
- Stagflation
- The simultaneous fall in output and rise in the price level caused by an adverse supply shock (an oil-price spike, a drought, a disrupted supply chain) that shifts SRAS left. It is the policymaker's dilemma because no single AD move cures both problems at once.
Aggregate Demand and Supply FAQ
Why does the aggregate demand curve slope downward?
For three distinct reasons a lower price level raises the total quantity of output demanded. The wealth effect: a lower price level raises the real value of money holdings, so consumers feel wealthier and spend more (C). The interest-rate effect: less money is needed for transactions, so interest rates fall and borrowing and investment rise (I) — this is the most important channel for Australia. The exchange-rate effect: lower rates depreciate the dollar, making exports cheaper abroad, so net exports rise (NX). The marker wants all three named and matched to a spending component.
What is the difference between moving along AD and shifting AD?
A change in the price level is a movement along a fixed AD curve, via the wealth, interest-rate and exchange-rate effects. A change in any component of spending for a reason other than the price level — a tax cut, a confidence collapse, a rate change, an export boom — shifts the whole AD curve. Confusing the two is the single most common AD-AS error, exactly mirroring the movement-vs-shift trap from the micro half.
Why is SRAS upward-sloping but LRAS vertical?
In the short run, sticky wages and prices (and misperceptions about relative prices) mean a higher overall price level lifts firms' output, so SRAS slopes up — but this only happens when the actual price level differs from what was expected. In the long run wages and prices fully adjust, so output is pinned to the economy's real productive capacity (the natural level) regardless of the price level, making LRAS vertical. The expected price level shifts SRAS but never LRAS — expectations cannot change real capacity.
How do a demand shift and a supply shift differ in their effects?
An AD shift moves output and the price level the same direction (both down in a recession, both up in a boom). An adverse SRAS shift moves them opposite ways (output down, price level up) — that is stagflation. A useful check: if your diagram shows output and prices falling together, you shifted AD, not SRAS. After a demand shift the economy self-corrects back to potential, so the long-run effect is only on the price level; a supply shock can change both.
Is AD-AS on the BEO6600 closed-book exam?
No. AD-AS (Session 10) falls after the Session 9 exam, which covers Sessions 1-8 only. It powers the 30% group research report and presentation, so the marker rewards reasoning, diagrams and policy judgement rather than arithmetic. Learn it well for the report, but don't burn exam-eve hours on it.
Exam move
The model earns its keep when you shift a curve and trace the path, so practise the two dominant cases. For a demand-side recession: AD left cuts output and prices short-run, then SRAS shifts right as wages fall until output is back on LRAS at a lower price level. For an adverse supply shock: SRAS left raises prices and cuts output together — stagflation, with no single AD cure. Name all three reasons AD slopes down and match each to its spending component (wealth→C, interest-rate→I, exchange-rate→NX), remembering the interest-rate effect leads for Australia. Keep the movement-vs-shift distinction sharp, and remember the expected price level shifts SRAS but never LRAS. Because this is a 30% group report, label both axes, all three curves and every equilibrium point — unlabelled diagrams lose marks.
