Variations in Economic Activity: AD and AS, IB 3.2 notes

The business cycle

Real output does not grow smoothly; it fluctuates around a rising long-run trend in what is called the business (or trade) cycle. The phases are expansion (rising real GDP, falling unemployment), a peak or boom (output near or above capacity, inflation pressure building), contraction or recession (defined as two consecutive quarters of falling real GDP), and a trough before recovery begins.

The long-run trend line reflects the economy's productive potential, while the cycle is the short-run deviation around it. Booms tend to bring inflationary pressure; recessions bring rising cyclical unemployment and spare capacity.

Aggregate demand and its determinants

Aggregate demand (AD) is total planned spending on domestic output at each average price level: AD = C + I + G + (X - M). The AD curve slopes downward because a lower price level raises real wealth, lowers interest rates and makes exports more competitive, all of which raise the quantity of output demanded. A change in the price level is a movement along AD; a change in any other determinant shifts the whole curve.

Consumption (C) shifts with consumer confidence, interest rates, wealth, income taxes and household debt. Investment (I) responds to business confidence and animal spirits, interest rates, corporate taxes, technology and retained profits. Government spending (G) reflects fiscal policy and political priorities. Net exports (X - M) depend on the exchange rate, incomes abroad, trade policy and relative inflation rates.

Short-run aggregate supply (SRAS)

Short-run aggregate supply shows total output firms are willing to produce at each price level while resource prices, especially wages, are fixed. It slopes upward because a higher output price with sticky input costs widens profit margins and encourages more production.

SRAS shifts when input costs change: a fall in oil or commodity prices, lower wage rates, cuts to business taxes or new subsidies, or a stronger currency lowering imported input costs all shift SRAS rightward. A supply shock such as a spike in energy prices shifts it leftward, raising the price level and cutting output at the same time.

The monetarist / new classical LRAS

In the monetarist or new classical model, long-run aggregate supply (LRAS) is a vertical line at the full-employment level of output, sometimes labelled Yf or potential output. It is vertical because in the long run wages and prices are fully flexible, so the economy always returns to its potential level and the price level has no effect on real output.

LRAS shifts only when the quantity or quality of factors of production changes: net investment, technological progress, a larger or better-trained labour force, higher productivity or improved institutions. This is the model that underlies the idea that only supply-side policy raises long-run growth, and that demand stimulus beyond Yf produces only inflation.

The Keynesian AS curve

The Keynesian aggregate supply curve is a single curve with three sections, and it matters because it changes the policy conclusion. In the horizontal (perfectly elastic) section, output is far below capacity in a deep recession, there is mass spare capacity, and firms can raise output without any rise in the price level because there is no upward pressure on wages or input costs.

As output rises toward capacity the curve becomes upward-sloping (the intermediate range), because bottlenecks appear in some industries and prices begin to rise. At full capacity the curve becomes vertical, like the monetarist LRAS, because no extra real output is physically possible. The key Keynesian assumption is that wages are sticky downward: they do not fall to clear the labour market in a slump, so the economy can become stuck below full employment.

Equilibrium and output gaps in both models

Macroeconomic equilibrium occurs where AD meets AS, setting the price level and real output. In the monetarist model the economy self-corrects: a fall in AD lowers output in the short run, but falling wages shift SRAS right until output returns to Yf, so long-run equilibrium is always at potential.

In the Keynesian model equilibrium can settle and stay in the horizontal or intermediate range, below full employment, because sticky wages block the self-correction. This persistent shortfall is a recessionary or deflationary gap (actual output below potential), and it is the theoretical justification for demand-side intervention: government must raise AD because the market will not close the gap on its own. An inflationary gap is the opposite, where AD pushes actual output temporarily above potential, generating demand-pull inflation. Explore both diagrams at /sandbox/adas.

Common Paper mistakes

Label your axes as average price level and real GDP, never price and quantity. Distinguish a movement along AD caused by a price-level change from a shift caused by a determinant. Do not present only the vertical LRAS: the syllabus expects you to know the Keynesian three-section curve too, and to state that in the Keynesian model equilibrium can persist below full employment, which is the point that justifies demand management.

How this is examined

• Paper 1 rewards fully labelled diagrams: use 'average price level' and 'real GDP', mark Yf, and show the shift direction clearly.
• Know both AS models: a Paper 1 (b) question can ask you to compare the monetarist vertical LRAS with the Keynesian curve, and the marks are in the different policy conclusions.
• State explicitly that the Keynesian model can rest below full employment, which is what justifies demand-side intervention: this sentence earns evaluation marks.
• Do not confuse a shift of AD with a movement along it, the single most common AD/AS error.

Key terms

aggregate demandaggregate supplyshort run aggregate supplylong run aggregate supplybusiness cycleoutput gap