From IS-LM to aggregate demand
The aggregate demand curve is not a market demand curve. It comes from IS-LM: a higher price level shrinks real money balances M/P, shifts LM left, raises the interest rate and lowers investment and output. Trace that out over every price level and you get a downward-sloping relationship between the price level and the output people want to buy.
In the explorer AD is built exactly that way, from the IS-LM model on this site with a marginal propensity to consume of 0.75. Anything that shifts IS or LM at a given price level shifts AD: government spending, taxes, confidence, and the nominal money supply.
Short-run and long-run supply
Long-run aggregate supply is vertical at natural output Yₙ, the level the economy produces when prices and wages have fully adjusted. It depends on labour, capital and technology, not on the price level.
Short-run aggregate supply slopes up because some prices and wages are set in advance on expected prices. If prices turn out higher than wage-setters expected, firms find it worth producing more. The explorer writes SRAS as P = Pᵉ(1 + (Y − Yₙ)/1200) + z, where Pᵉ is the expected price level and z a supply shock. When the price level equals what was expected, output is at its natural level.
A demand expansion, short run and long run
Raise government spending by 50. AD shifts right, and in the short run output rises from 2,300 to about 2,356 and the price level from 1.00 to about 1.05: part of the extra demand shows up as output and part as prices, because SRAS slopes up.
That isn’t the end. Prices are now above what wage-setters expected, so at the next round they expect more, and SRAS shifts up. Output falls back towards 2,300 while prices keep rising, until the economy settles on LRAS at a price level of about 1.11. Drag SRAS up yourself and watch the output gap close.
Money in the long run
Raise the nominal money supply by 10% and output rises in the short run, to about 2,353. In the long run output returns to its natural level and the price level ends up 10% higher, at 1.10, exactly in proportion to the money supply. Real money balances are back where they started.
That is long-run money neutrality, and it is why the AD-AS model sits at the centre of debates about what monetary policy can and can’t do. Money can move output while expectations are catching up, but not after.
Supply shocks and stagflation
A sharp rise in the price of oil raises costs at every level of output, shifting SRAS up. Output falls, to about 2,247 in the explorer, while the price level rises to about 1.06. Falling output and rising prices together is stagflation, the experience of many economies after the oil shocks of the 1970s.
A supply shock leaves policymakers with an awkward choice. Expanding demand restores output faster but pushes prices higher still; holding demand steady lets the recession do the work of bringing prices back down. Exam questions about this trade-off often lead into the Phillips curve.
Reading the diagram in an exam
Label the axes as the price level and real output, and draw LRAS, SRAS and AD meeting at one point to start from a long-run equilibrium. Then make one change at a time: shift a curve, mark the short-run equilibrium, explain the adjustment in expectations, and mark where the economy ends up.
Say which way each curve moved and why. Most marks go to the mechanism, such as higher prices raising expected prices and shifting SRAS, rather than to the final picture alone.