AD-AS model
/ A-D A-S /
How do you explain, in one picture, why an economy might suddenly have both rising prices and falling output, or a boom that overheats, or a slump that drags on? Economists use a single diagram that pits the whole economy's spending against the whole economy's production. The AD-AS model puts the overall price level on the vertical axis and total real output on the horizontal axis, then draws aggregate demand and aggregate supply on the same graph to find where the economy settles.
It has three curves. Aggregate demand (AD) slopes downward — lower price levels mean more total spending. Short-run aggregate supply (SRAS) slopes upward — with sticky costs, higher prices coax out more output. Long-run aggregate supply (LRAS) is a vertical line at potential output. The economy's short-run equilibrium is where AD crosses SRAS, fixing the current price level and output. Its long-run resting place is where AD crosses LRAS. Shift any curve and you read off the consequences: a fall in AD (say, panicked consumers) pushes the AD line left, lowering both output and prices in the short run — a recession. A supply shock (say, an oil spike) pushes SRAS left, raising prices while cutting output — stagflation.
The AD-AS model is the workhorse for thinking about the business cycle and short-run policy, because it separates two questions that beginners often blur: what determines prices versus what determines output, and over what horizon. Its great strength is showing that demand drives output in the short run while capacity rules the long run. Its honest limit is that it is a simplification — a single price level and a single output number standing in for a vast, messy economy — so it guides intuition more than it predicts exact magnitudes, and it assumes other things equal (ceteris paribus).
When the 1970s oil embargo quadrupled energy costs, economists drew it as the SRAS curve shifting left: at the new intersection with unchanged demand, prices were higher and output lower at the same time — the diagram's neat picture of stagflation, which older models struggled to explain.
AD-AS on one graph: where the curves cross sets the price level and output; shifts explain booms, busts, and stagflation.
The AD-AS curves are not the same as single-market supply and demand — the axes are the price level and total output, and the slopes come from macroeconomic effects, not from one good getting relatively pricier. Treating them like a big micro diagram leads to wrong conclusions.