Aggregate demand and aggregate supply - TCE Economics (Tasmania)
“Use the aggregate demand and aggregate supply model to explain how the equilibrium level of real output and the price level are determined and how they change.”
Aggregate demand is total planned spending in the economy and aggregate supply is total planned output. Where they meet sets the equilibrium level of real output and the price level, and shifts in either one change growth, employment and inflation together.
What this dot point is asking
The aggregate demand and aggregate supply (AD-AS) model scales the single-market diagram up to the whole economy. Instead of the price and quantity of one good, the axes show the general price level and real Gross Domestic Product. The model explains how growth, unemployment and inflation are determined at the same time.
Aggregate demand
Aggregate demand (AD) is the total planned spending on Australian-produced goods and services at each price level. It has four components.
Here C is household consumption, I is business investment, G is government spending, and (X - M) is net exports. The AD curve slopes downward: a lower general price level raises real wealth, lowers interest rates and makes exports more competitive, so more is bought. AD shifts when any component changes for a reason other than the price level, such as a cut in the cash rate lifting consumption and investment, a budget stimulus raising G, or a fall in the dollar boosting net exports.
Consumption, investment, government spending and net exports. Anything that changes one of these (interest rates, confidence, the budget, the exchange rate, world growth) shifts the whole AD curve.
Aggregate supply
Aggregate supply (AS) is the total output firms plan to produce at each price level. Its shape captures how close the economy is to capacity.
- When there is plenty of spare capacity, the curve is fairly flat: firms can lift output with little rise in prices.
- As the economy nears full capacity, the curve steepens: extra demand pushes up prices more than output because labour and materials become scarce.
- At full capacity the curve is vertical: output cannot rise further, so extra demand only raises prices.
AS shifts with changes in production conditions: input costs such as wages and oil prices, productivity and technology, and the supply of resources. A drought, an oil price spike or a wage surge shifts AS left; productivity gains or cheaper inputs shift it right.
The total quantity of goods and services that firms in an economy plan to produce and sell at each general price level over a given period.
Macroeconomic equilibrium
Equilibrium is where AD meets AS, setting the equilibrium real output and price level. If planned spending exceeds output, firms run down stocks and expand, lifting output and prices. If output exceeds spending, stocks build up and firms cut back. The economy settles where the two are equal.
Demand-side and supply-side shocks
A rightward shift in AD (a demand shock such as a stimulus package or a rate cut) raises real output and employment, but if the economy is near capacity it also raises the price level, causing demand-pull inflation. A leftward shift in AD lowers output and employment and eases inflation.
A leftward shift in AS (a supply shock such as a spike in energy prices) raises the price level while lowering output, a painful combination known as stagflation. A rightward shift in AS, from productivity gains, raises output and lowers prices at the same time, which is the ideal outcome.
Step 1: Set the starting point
The economy is near full capacity: unemployment is already low and spare capacity is small.
Step 2: Apply the shock
The government delivers a large infrastructure package, raising G. This shifts the AD curve to the right.
Step 3: Locate the relevant part of AS
Because the economy is near capacity, the AS curve is steep in this region. Labour and materials are scarce, so firms cannot easily expand output.
Step 4: Read the new equilibrium
Most of the rightward AD shift turns into a higher price level rather than higher real output. Real GDP rises only modestly while inflation accelerates, which may prompt the RBA to raise the cash rate to cool demand.
A change in the general price level causes a movement along the AD curve, not a shift. Only a change in C, I, G or net exports for a non-price reason shifts AD. Label the cause before deciding whether the curve moves or shifts.
The AD-AS model is the engine room of macroeconomics. It shows why a booming economy tends to inflate, why a recession brings unemployment, and why supply-side reform matters: shifting AS right is the only way to raise output without raising prices. Fiscal and monetary policy work mainly by shifting AD, which is why their effects on inflation depend on how close the economy is to capacity.
Exam-style questions
Questions in the style of TASC exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
PracticeDescribe consumption expenditure and investment expenditure as components of aggregate demand. Explain one (1) factor that influences consumption expenditure and one (1) factor that influences investment expenditure.Show worked answer →
Aggregate demand (AD = C + I + G + (X - M)) is total planned spending on domestically produced goods and services at each price level. Two of its components are:
Consumption expenditure (C). Spending by households on goods and services, the largest component of AD. A factor that influences it: the level of disposable income (or consumer confidence or interest rates). For example, higher disposable income or stronger confidence raises consumption; higher interest rates reduce it by raising the cost of credit and the reward for saving.
Investment expenditure (I). Spending by firms on new capital goods such as plant, equipment and buildings. A factor that influences it: interest rates (or business expectations/profits). For example, lower interest rates reduce the cost of borrowing, making more projects profitable and raising investment; pessimistic expectations of future demand reduce it.
A strong answer defines each component, identifies one valid determinant for each, and states the direction of the effect on the component (and hence on AD).
PracticeUsing a diagram of the Australian economy, illustrate and explain how increases in labour productivity would impact the Australian economy. Referring to your diagram, why might increases in labour productivity decrease the likelihood of further interest-rate hikes?Show worked answer →
Diagram. On an aggregate supply and aggregate demand diagram (price level against total output), an increase in labour productivity shifts aggregate supply to the right. The new macroeconomic equilibrium has higher real output (Ye rises) and a lower price level (Pe falls) for a given level of aggregate demand.
Explanation. Higher labour productivity means more output per hour worked, lowering firms' unit costs of production. Firms can supply more at each price level, expanding the economy's productive capacity. This raises real GDP and employment while easing cost pressures on prices.
Link to interest rates. Because the rightward shift in aggregate supply lowers the price level (or slows inflation), it reduces inflationary pressure without the need to cut demand. The RBA raises the cash rate mainly to curb demand-driven inflation, so if productivity growth eases inflation from the supply side, there is less need for further rate hikes to bring inflation back to the 2 to 3 per cent target.