The aggregate demand – aggregate supply (AD–AS) model is useful for analyzing changes in both real GDP and the price level. Changes in either aggregate demand, aggregate supply, or both can help to explain recession and unemployment, inflation, and economic growth.

Exploration: How do changes in aggregate demand and supply affect the equilibrium price level and real GDP?

The graph shows the aggregate demand and aggregate supply curves for a hypothetical economy. The AD curve shows an inverse relationship between the aggregate price level and real GDP. This is because an increase in the price level: 1) reduces the real value of dollar-denominated assets, which reduces consumption expenditures; 2) increases the demand for money, which increases interest rates and thereby reduces investment expenditures; and 3) makes domestically produced goods less attractive to foreigners, which reduces net exports.

The aggregate supply curve, on the other hand, reflects the costs of producing a given level of GDP. At very low levels of GDP, resources are unemployed and output may increase with little upward pressure on the price level. However, as real GDP approaches full employment, bottlenecks for some resources appear and costs begin to rise. The price level must rise sufficiently to cover these higher production costs.

The economy is initially at the full employment level of real GDP, labeled Q₀, and the price level is stable at price level P. To use the graph, click and drag either the AD or AS labels to shift the aggregate demand or aggregate supply curve, respectively, to a new location. Clicking Reset will restore the economy to full employment GDP and a stable price level. Click Update to establish the new equilibrium as a starting point for additional analysis.