Aggregate Supply and Demand
The aggregate supply and demand (AD-AS) model constitutes the central analytical framework of macroeconomics. Mankiw presents it as the fundamental tool for understanding short-run economic fluctuations: how the general price level and total output are determined, and how economic shocks and policies affect them.
Last updated: 8 July 2026
Definition
DefinitionThe AD-AS (Aggregate Demand - Aggregate Supply) model relates the general price level to the total quantity of goods and services produced in the economy (real GDP).
The aggregate demand curve (AD) represents the inverse relationship between the price level and the total quantity of goods and services demanded: when prices fall, agents consume and invest more, through the combined play of three mechanisms — the wealth effect, the interest rate effect, and the exchange rate effect. The aggregate supply curve (AS) represents the relationship between the price level and the quantity firms are willing to produce.
A careful distinction is drawn between short-run aggregate supply (SRAS), which slopes upward in prices (firms produce more when prices rise because some costs are rigid), and long-run aggregate supply (LRAS), which is vertical at the level of potential GDP. Three models explain the positive slope of the SRAS: the sticky-wage model (W set by contract), the sticky-price model (P adjusted with a lag), and the misperception model (confusion between relative prices and the general price level).
Why it matters
The AD-AS model is the main tool used by economists to analyze the causes of recessions, the mechanisms of inflation, and the effectiveness of stabilization policies. Mankiw introduces and develops it by showing how demand and supply shocks explain the major economic crises: the Great Depression of 1929 (massive negative demand shock), the oil shocks of 1973 and 1979 (negative supply shocks), and the Covid-19 pandemic (simultaneous shock on supply and demand).
The three models of short-run aggregate supply all lead to the same equation: Y = Ȳ + α(P − Pᵉ), where Ȳ is natural output, P the actual price level, Pᵉ the expected price level, and α a positive parameter measuring the responsiveness of output to price surprises.
Mankiw stresses the fundamental distinction between short-run and long-run effects: in the short run, demand policies (monetary and fiscal) influence output and prices because prices are sticky. In the long run, output returns to its natural level and only prices adjust, in line with the verticality of the LRAS curve.
Key points
A positive demand shock (rise in public spending, rate cut) shifts the AD curve to the right, which raises both output and prices in the short run. In the long run, output returns to its natural level and only prices have risen
A negative supply shock (oil price rise, pandemic) shifts the SRAS curve to the left, simultaneously triggering a fall in output and a rise in prices (stagflation). This is the most feared scenario because no demand-side policy can correct both problems at the same time — only a supply-side policy (lower production costs, productivity gains) can in theory fix both
Automatic long-run adjustment goes through the flexibility of prices and wages: in recession, the gradual decline in wages reduces production costs and shifts the SRAS curve to the right, bringing output back to potential. This adjustment can, however, take several years
The stagflationary dilemma confronts decision-makers with an impossible trade-off: an expansionary policy reduces the recession but worsens inflation, a restrictive policy reduces inflation but worsens the recession
Concrete example
ExamplesThe 1973 oil crisis illustrates the negative supply shock: the embargo declared by OPEC's Arab members, combined with the cartel's price increases, quadrupled the oil price in a few months, brutally raising production costs across the world economy. The aggregate supply curve shifted to the left, simultaneously causing a recession (GDP fell) and double-digit inflation in many industrialized countries. The Covid-19 pandemic in 2020 was an unprecedented dual shock: lockdowns reduced supply (factory closures, logistical disruptions) and demand (mobility restrictions, uncertainty) simultaneously, triggering the most brutal recession since World War II. The 2021-2022 episode provides the most recent textbook case: at the reopening, excess demand (accumulated savings, massive fiscal stimulus) met constrained supply (clogged supply chains, then the 2022 surge in energy prices), pushing inflation to its highest level in forty years and reviving stagflation fears. The sharp monetary tightening that followed drove equity and bond markets down simultaneously in 2022 — the characteristic configuration of a negative supply shock.
Mankiw anecdote
MankiwMankiw uses the AD-AS model to explain the debate on stimulus effectiveness: if the economy is far below its potential (wide negative output gap), the SRAS curve is relatively horizontal and stimulus mainly raises output with little effect on prices. If the economy is near full employment, the SRAS curve is steeper and stimulus mainly generates inflation.
📊 Modèle AD-AS
Market impact
MarketsNegative supply shocks are the most feared by financial markets because they produce stagflation, a situation in which central banks cannot cut rates (because of inflation) yet cannot raise them without worsening the recession. Equity and bond markets suffer simultaneously in this scenario. Positive demand shocks (stimulus plans) are initially well received by equity markets but push bond yields up in anticipation of future inflation.