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The AD/AS model is the central analytical framework of A-Level macroeconomics — the place where the demand side and the supply side finally meet to determine the equilibrium price level and equilibrium real output. Everything you have studied so far feeds into it: the components of aggregate demand, the slope of SRAS, the contested shape of LRAS, the multiplier. Its power is that it can analyse, on a single diagram, both a demand-side shock (a sudden change in C, I, G or net trade) and a supply-side shock (a sudden change in costs or capacity), and show how each affects prices and output differently — and differently again depending on whether you draw aggregate supply the classical or the Keynesian way. This lesson establishes how equilibrium is set, traces the two families of shock, and applies the model to the three defining macro episodes of the modern UK: the 2008 financial crisis, the COVID-19 pandemic and the 2022 energy shock.
This lesson maps to AQA 7136 section 4.2.2 — How the macroeconomy works: AD/AS analysis and the determination of equilibrium output, drawing on 4.2.3 (inflation, cost-push and demand-pull) and feeding 4.2.5 (policy responses to shocks). It is examined in Paper 2 (National and international economy) and is heavily synoptic with Paper 3, where almost every case study is, at bottom, an AD/AS shock analysis. All four assessment objectives apply: AO1 for the equilibrium concept and the two types of shock; AO2 for applying the framework to real UK episodes and data; AO3 for chains of reasoning from a shock through the curves to a new equilibrium; and AO4 for evaluating the policy dilemmas shocks create and the classical-versus-Keynesian divergence in how the economy adjusts.
Macroeconomic equilibrium occurs where the AD curve intersects the AS curve. At that intersection the quantity of real output demanded equals the quantity supplied; there is no tendency for the price level or output to change in the absence of a shock; and the price level and real GDP are simultaneously determined.
In the classical model there is a short-run and a long-run equilibrium. Short-run equilibrium is where AD meets SRAS; long-run equilibrium is where AD, SRAS and the vertical LRAS all coincide. If the economy is knocked away from LRAS, wages and prices adjust to drag it back.
| Disturbance | Short run | Long-run adjustment back to Yn |
|---|---|---|
| AD rises | Output rises above Yn; price level rises | Workers demand higher pay to match inflation → wages rise → SRAS shifts left → output returns to Yn at a higher price level |
| AD falls | Output falls below Yn; price level falls | Unemployment pushes wages down → costs fall → SRAS shifts right → output returns to Yn at a lower price level |
The classical punchline is that AD changes affect output only temporarily; in the long run they affect only the price level, because the economy self-corrects to the vertical LRAS.
In the Keynesian model the economy can settle anywhere along the L-shaped AS curve, and — crucially — equilibrium need not be full employment:
The defining Keynesian insight is that the economy can come to rest, and stay, with substantial unemployment if AD is deficient — there is no automatic force returning it to full employment. This single difference — self-correcting vertical LRAS versus a stable below-capacity Keynesian equilibrium — is why the same shock yields different conclusions in the two models, and it is the spine of most top-band evaluation.
It is worth being explicit about why the intersection is an equilibrium, because the AO3 marks lie in the mechanism, not the picture. Suppose the price level were above the equilibrium. At that higher price level, the quantity of real output demanded (read off AD) is less than the quantity firms are willing to supply (read off AS): there is a glut. Firms cannot sell all they produce, stocks pile up, and they respond by cutting prices and trimming output — pushing the price level down towards equilibrium. Conversely, if the price level were below equilibrium, the quantity demanded would exceed the quantity supplied: a shortage, with stocks running down and firms raising prices and output, pushing the price level up towards equilibrium. Only at the intersection is there neither glut nor shortage, so neither the price level nor output has any tendency to move. This is the macroeconomic analogue of micro market-clearing, and stating it — excess supply above equilibrium pushes prices down, excess demand below equilibrium pushes prices up — turns a description of the diagram into genuine analysis.
Exam Tip: Always label both axes (price level vertical, real GDP horizontal), label every curve, and mark the equilibrium price level and output with dashed guide-lines. When a shock could be analysed either way, state which AS model you are using and why — examiners reward candidates who flag the classical/Keynesian choice rather than blurring it.
A demand-side shock is a sudden, unexpected shift in aggregate demand — a change in C, I, G or net trade for a reason other than the price level.
| Shock | Mechanism | Effect on price level and output |
|---|---|---|
| Tax cuts | Higher disposable income → higher C | Output rises; price effect depends on spare capacity |
| Interest-rate cuts | Cheaper borrowing → higher C and I | Output rises; sustained cuts may inflate asset prices |
| Confidence rises | Households and firms spend and invest more | AD rises; confidence is self-reinforcing |
| Sterling depreciation | Exports cheaper, imports dearer → net trade up | AD rises (though it can also push SRAS left via dearer imported inputs) |
| Quantitative easing | Asset purchases lower long-term rates, lift asset prices | AD rises, via an uncertain transmission mechanism |
| Shock | Mechanism | Effect on price level and output |
|---|---|---|
| Financial crisis | Credit crunch → C and I collapse | Sharp fall in output, rising unemployment, possible deflation |
| Fiscal austerity | Cuts to G, rises in T | AD falls — magnified by the multiplier |
| Global recession | Falling overseas demand → exports decline | AD falls — painful for export-dependent economies |
| Confidence collapse | Fear → precautionary saving → C falls | Self-reinforcing downward spiral — Keynes's paradox of thrift |
| Interest-rate rises | Dearer borrowing → lower C and I | AD contracts — the Bank's main inflation-control tool |
The defining feature of a demand-side shock is that price and output move in the same direction — both fall in a slump, both rise in a boom. This is the diagnostic that distinguishes it from a supply shock.
A supply-side shock is a sudden, unexpected change in the costs of production or in productive capacity, shifting SRAS (and, if capacity is affected, LRAS).
| Shock | Example | Effect |
|---|---|---|
| Oil/gas price spike | 1973 OPEC embargo; 2022 Russia–Ukraine war | Costs rise economy-wide → SRAS left → stagflation (higher prices and lower output) |
| Pandemic | COVID-19 (2020) | Labour supply falls, supply chains disrupted → SRAS left |
| Natural disaster | Major earthquakes, severe flooding | Productive capacity destroyed → SRAS and possibly LRAS left |
| Trade frictions | New customs checks and border costs | Higher cost of importing/exporting → SRAS left |
| Wage-push | Pay rising faster than productivity | Higher unit labour costs → SRAS left |
| Shock | Example | Effect |
|---|---|---|
| Technological breakthrough | The internet (1990s); AI applications (2020s) | Costs fall, productivity rises → SRAS right → lower prices, higher output |
| Commodity-price fall | Oil-price collapse (2014–15) | Lower input costs economy-wide → SRAS right |
| Inward migration | EU enlargement (2004) | Larger labour supply restrains wage costs → SRAS right |
| Deregulation | Lower compliance costs | SRAS right, though typically with a lag |
The diagnostic for a supply-side shock is the opposite of a demand shock: price and output move in opposite directions. An adverse SRAS shift raises prices while cutting output — which is exactly why it is so much harder to deal with than a demand shock.
This contrast deserves to be elevated into a single, reliable rule of thumb that unlocks almost any data-response shock question. Look at what happens to the price level and to output, and read the cause backwards. If prices and output move in the same direction — both up, or both down — the shock is on the demand side, because shifting AD along an upward-sloping AS curve always moves price and quantity together. If prices and output move in opposite directions — prices up while output falls, or prices down while output rises — the shock is on the supply side, because shifting AS along a downward-sloping AD curve always moves price and quantity in opposite directions. So a recession with falling inflation is a demand-side recession (2008–09); a recession with rising inflation is a supply-side shock (1973, 2022, the stagflation signature). This single test lets you classify the shock from the data alone, choose the right curve to shift, and select an appropriate policy — which is precisely the chain of judgement (AO2 to AO4) that the data-response and essay mark schemes reward. The reason it matters so much for policy is that the cure differs by type: a demand shock can be offset cleanly by a demand-side policy in the opposite direction, whereas a supply shock confronts demand-side policy with a trade-off and is properly addressed only by supply-side measures.
Stagflation — stagnation (falling output, rising unemployment) together with inflation — is the signature of an adverse supply-side shock.
| Feature | Explanation |
|---|---|
| Output falls | Higher costs cut production at every price level |
| Unemployment rises | Falling output sheds labour |
| Prices rise | Higher costs are passed on — cost-push inflation |
| Policy dilemma | Expansionary policy to support output worsens inflation; contractionary policy to curb inflation deepens the recession |
Stagflation is so important for evaluation precisely because it breaks the comfortable demand-side trade-off. With a demand shock, one policy lever fixes everything — stimulate a slump, tighten a boom. With a supply shock, any demand-side response makes one problem worse while easing the other; there is no clean fix. Stagflation first hit on a large scale in the 1973 oil crisis, discrediting the then-orthodox belief in a stable Phillips-curve trade-off between inflation and unemployment. Milton Friedman (1968) and Edmund Phelps (1968) had predicted exactly this breakdown once inflation expectations adjusted, and stagflation vindicated them.
Exam Tip: Stagflation is the killer evaluation point for any "is demand management effective?" question. It shows demand-side policy alone cannot solve a supply-side problem without a trade-off — the only durable answer is supply-side policy that shifts SRAS/LRAS back to the right, which works only with a lag. Deploying this distinction signals genuine command of the model.
The 2008 crisis was primarily a negative demand-side shock — a credit crunch that collapsed C and I — though it left lasting supply-side scars.
| Phase | What happened | AD/AS effect |
|---|---|---|
| 2007–08 credit crunch | US subprime crisis went global; Northern Rock failed (Sep 2007); Lehman Brothers collapsed (Sep 2008) | Banks stopped lending → AD shifted sharply left |
| 2008–09 recession | UK real GDP fell about 4.2% in 2009; unemployment rose from 5.2% to 7.9% | Large negative output gap |
| 2009–12 policy response | Bank Rate cut to 0.5%; QE began (£200bn initially); fiscal stimulus, then austerity from 2010 | Attempt to shift AD back right |
| 2012–16 slow recovery | Growth returned below the pre-crisis trend; productivity stagnated | AD recovered, but LRAS may have been permanently scarred |
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