Aggregate demand and aggregate supply

See how a change in monetary policy shifts aggregate demand, and how the new short-run equilibrium depends on the slope of SRAS and on where the economy starts.

A theoretical model. It shows the direction of changes, not forecasts: the axes have no units and the shift sizes are illustrative.

Contractionary monetary policy

The central bank raises its policy interest rate.

Average price level: FallsP₁ to P₂
Real GDP: FallsY₁ to Y₂
Output gap: The inflationary gap almost closes: Y₂ ends just above potential output (Y₂ ≈ Yf), so a small inflationary gap remains.

How it works

1The central bank raises its , and commercial banks raise the rates they charge and pay.
2Borrowing becomes more expensive and saving more rewarding, so and fall. A stronger currency can also reduce net exports.
3Aggregate demand shifts left from AD₁ to AD₂.
4At the original price level there is now excess supply, so the economy moves down along SRAS to a new equilibrium.
5In the model, the average price level falls from P₁ to P₂ and real GDP falls from Y₁ to Y₂.
6The diagram compares two equilibria with everything else held constant, so P₂ is lower than the price level would have been without the policy. In an economy where prices are already rising, that shows up as (prices rising more slowly). It is not necessarily (prices actually falling).

Flatter SRAS. Assumes firms can expand output without much upward pressure on costs, as when there is spare capacity. More of a demand change then shows up in real GDP.

Inflationary gap. The economy starts above potential output, the situation in which contractionary policy is typically used.

The slope of SRAS and the starting point are set separately so you can compare their effects. They are assumptions, not readings of each other: in practice an economy above potential is more likely to face a steep SRAS.

Follow every link in the Reasoning Lab

Assumptions in this model

The axes are unitless. Positions show the direction and relative size of changes, not forecasts of any real economy.
AD and SRAS are drawn as straight lines for clarity.
Monetary policy is modelled as a shift of AD only. SRAS and LRAS are held constant (ceteris paribus).
This is a short-run analysis. Wages and other input prices are fixed along SRAS, and long-run adjustment is not shown.
This model draws the monetarist/new classical short run. It does not draw the Keynesian AS curve. On the horizontal section of that curve a change in AD alters real GDP with no change in the price level; a flatter SRAS only approximates this.
‘Smaller’ and ‘larger’ shifts are illustrative. They are not calibrated to any particular change in interest rates.
The slope of SRAS and the starting output gap are chosen independently so their effects can be compared. In reality they are related: an economy above potential output usually faces a steeper SRAS.
Real GDP within about 1% of the axis length of potential output is described as approximately at potential (Y₂ ≈ Yf). Exact equality is shown as Y₂ = Yf.
The diagram is comparative-static: it compares the equilibrium before and after a shift with everything else held constant, and it has no time axis. A lower P₂ therefore means a price level lower than it would have been without the policy. The model cannot show whether prices then rise more slowly (disinflation) or actually fall (deflation). That depends on how fast prices were rising to begin with and on how much demand is reduced. With inflation above target, the usual result is disinflation.