Business Economics · Business activity, unemployment and inflation

Aggregate Demand and Aggregate Supply: The AD-AS Model Explained

Updated 11 October 2026 · Fact-checked

The AD-AS model shows how the economy's total demand for output and total supply of output together set the price level and real output. Equilibrium is where the AD curve meets the AS curve. To solve questions, identify what shifted, move the right curve, and read off the new price level and output.

Understand Aggregate Demand and Aggregate Supply

Aggregate demand (AD) is the total planned spending on a country's output at each price level. It is made up of consumption (C), investment (I), government spending (G) and net exports (X − M). The AD curve slopes downward. A higher price level reduces the real value of money balances, raises interest rates and makes exports dearer, so planned spending falls.

Aggregate supply (AS) is the total output firms are willing to produce at each price level. The AS curve is drawn in two ways because firms behave differently in the short run and the long run.

The short-run aggregate supply (SRAS) curve slopes upward. In the short run, some costs such as wages are sticky. If prices rise while wages stay fixed, profit per unit rises and firms produce more. The long-run aggregate supply (LRAS) curve is vertical in the classical view. In the long run, wages and other input prices adjust fully, so output depends on the economy's productive capacity (labour, capital, technology), not on the price level. This level is potential output.

Equilibrium is where AD meets SRAS. Short-run equilibrium can be below, at or above potential output. If output is below potential, there is a recessionary (deflationary) gap. If it is above potential, there is an inflationary gap. Over time, wages and costs adjust and SRAS shifts until the economy returns to the LRAS level.

Curves shift for reasons other than a change in the price level. A change in the price level moves you along a curve. A change in any other factor shifts the whole curve. This one distinction decides most exam questions.

Key rules to remember

Aggregate demand components: AD = C + I + G + (X − M); A rise in any component, at the same price level, shifts AD to the right. A fall shifts it left.
Short-run equilibrium: AD = SRAS; This sets the short-run price level and real output. Solve the two equations together when they are given as numbers.
Long-run equilibrium: AD = SRAS = LRAS; Output equals potential output. The price level is where AD crosses the vertical LRAS.
Output gap: Output gap = actual output − potential output; Positive means an inflationary gap. Negative means a recessionary gap.
Shift versus movement: Price level change → movement along the curve; any other factor → shift of the curve; State this explicitly in written answers.

How to solve Aggregate Demand and Aggregate Supply questions

Use this method for any AD-AS question, whether it is a diagram, a numerical equilibrium or a policy shock.

1Identify the time frame: short run (sticky wages, SRAS upward sloping) or long run (LRAS vertical at potential output).
2Classify the event. Does it change spending (AD) or costs and capacity (SRAS or LRAS)? A change in the price level itself is only a movement along a curve.
3Decide the direction of the shift. More spending, a lower interest rate or a weaker currency shifts AD right. Higher input costs shift SRAS left. Better technology or more labour shifts both SRAS and LRAS right.
4Find the new short-run equilibrium where the new curve cuts the other curve. State what happens to the price level and real output.
5Compare output with potential output and name the gap, recessionary or inflationary.
6Describe the adjustment to the long run: wages and costs move, SRAS shifts, and the economy returns to LRAS. Name the final price level and output.
7For numerical questions, set AD equal to SRAS algebraically, solve for the price level first, then substitute to find output. Check by substituting into both equations.

Quickest way: Shift-and-read method

When to use it: Use it for multiple-choice questions on the direction of price level and output after a shock.

Ask: does the shock hit spending or costs?
If spending, shift AD. Price level and output move in the same direction in the short run.
If costs rise, shift SRAS left. Price level rises and output falls (stagflation).
If supply capacity grows, shift SRAS right (and LRAS). Price level falls and output rises.
If the question asks about the long run with a demand shock, output returns to potential and only the price level changes.

Common mistakes in Aggregate Demand and Aggregate Supply

Treating a change in the price level as a shift of AD.
The price level is on the vertical axis, so students think any price change moves the curve.
Fix: A price level change moves you along AD. Only a non-price factor such as G, taxes, confidence or exchange rate shifts it.
Drawing the long-run AS curve as upward sloping.
Students merge the short-run and long-run curves into one.
Fix: Draw LRAS vertical at potential output. Say that in the long run input prices fully adjust, so price level does not change output.
Saying a rise in the price level raises aggregate demand.
Confusion with supply, where higher prices raise output.
Fix: Along AD, a higher price level reduces planned spending through wealth, interest rate and trade effects. Remember AD slopes down.
Forgetting to describe the move back to the long run.
Students stop at the first short-run equilibrium.
Fix: Add a final step: if output differs from potential, wages adjust, SRAS shifts, and output returns to potential, leaving only the price level changed.
Shifting both curves for a single shock without reason.
Students overcomplicate the diagram.
Fix: Shift only the curve the shock affects. Add a second shift only if the question gives a second effect, such as a technology gain raising both SRAS and LRAS.

Worked examples

Example 1

An economy is at long-run equilibrium. Government spending rises sharply and nothing else changes. Describe the short-run and long-run effects on the price level and real output using the AD-AS model.

Show the solution

Government spending is a component of AD, so AD shifts right.
Short run: the new AD cuts the upward-sloping SRAS at a higher price level and higher output. Output is now above potential, an inflationary gap.
With output above potential, labour and inputs are in tight supply, so wages and costs rise.
Higher costs shift SRAS left. This continues until SRAS cuts the new AD at the LRAS level of output.
Long run: output returns to potential, and the price level is higher than at the start.

Answer: Short run: price level and output both rise. Long run: output returns to potential output, and only the price level is permanently higher.

Example 2

In an economy, AD is given by P = 120 − 2Y and SRAS by P = 30 + Y, where P is the price level index and Y is real output in ₹ thousand crore. (a) Find the short-run equilibrium. (b) Costs then rise so that SRAS becomes P = 45 + Y. Find the new equilibrium and describe the change.

Show the solution

(a) Set AD equal to SRAS: 120 − 2Y = 30 + Y.
Rearrange: 90 = 3Y, so Y = 30.
Substitute into SRAS: P = 30 + 30 = 60. Check with AD: 120 − 2(30) = 60. Correct.
(b) Set 120 − 2Y = 45 + Y.
Rearrange: 75 = 3Y, so Y = 25.
Substitute: P = 45 + 25 = 70. Check with AD: 120 − 2(25) = 70. Correct.
Compare: price level rose from 60 to 70 and output fell from 30 to 25. SRAS shifted left.

Answer: (a) Y = 30 (₹30 thousand crore), P = 60. (b) Y = 25, P = 70. Higher costs shifted SRAS left, raising the price level and reducing output, which is stagflation.

Exam tips

In written answers, draw a clear diagram with labelled axes (price level, real output), and label AD, SRAS, LRAS and each equilibrium. Then explain in words.
Always state the reason a curve shifts. Marks go to the cause, not just the direction.
For numerical questions, solve for P first by equating the two equations, then find Y. Show a substitution check.
State clearly whether you are using the classical vertical LRAS or a Keynesian view, since the IAI course discusses different schools, and explain the difference if asked.
In multiple-choice questions, check whether the question asks about the short run or long run before choosing.

Practice questions from Business activity, unemployment and inflation

Aggregate Demand and Aggregate Supply: frequently asked questions

What is the difference between short-run and long-run aggregate supply?

Short-run aggregate supply slopes upward because some input prices, especially wages, are sticky. Long-run aggregate supply is vertical at potential output because all prices adjust fully. In the long run, output depends on capacity, not the price level.

What shifts the aggregate demand curve?

Any change in C, I, G or net exports at a given price level shifts AD. Examples are tax changes, interest rate changes, consumer confidence, government spending and exchange rates. A change in the price level only moves you along the curve.

What shifts aggregate supply?

SRAS shifts when input costs such as wages or oil prices change, or when productivity changes. LRAS shifts when productive capacity changes, for example through more labour, more capital or better technology.

How do I find equilibrium output in the AD-AS model?

Set the AD equation equal to the SRAS equation and solve for the price level or output. Then substitute back to find the other variable. Check the answer in both equations.