AD-AS Model Explained

A timely post for my macro classes since we’re starting on the Aggregate Demand-Aggregate Supply (AD-AS) model this week. From

Economic growth is an increase in real GDP. It means an increase in the value of goods and services produced in an economy. The rate of economic growth measures the annual percentage increase in real GDP. There are several factors affecting economic growth, but it is helpful to split them up into:

For graphs and explanations, click the more button:

Demand Side Factors Influence Growth of Aggregate Demand (AD)

AD= C+I+G+X-M. Therefore a rise in Consumption, Investment, Government spending or exports can lead to higher AD and higher economic growth.

Graph Showing Rise in AD

What Could Affect AD?

Interest Rates. Lower interest rates would make borrowing cheaper and should encourage firms to invest and consumers to spend. People with mortgages will have lower monthly mortgage payments so more disposable income to spend. However, recently we had a period of zero interest rates, but due to low confidence and reluctant banks growth was still sluggish.

Consumer Confidence. Consumer and business confidence is very important for determining economic growth. If consumers are confident about the future they will be encouraged to borrow and spend. If they are pessimistic they will save and reduce spending.

Asset Prices. Rising house prices create a positive wealth effect. People can remortgage against the rising value of their home and this encourages more consumer spending. House prices are an important factor in the UK, because so many people are homeowners.

Real Wages. Recently, the UK has experienced a situation of falling real wages. Inflation has been higher than nominal wage, causing a decline in real incomes. In this situation, consumers will have to cut back on spending reducing their purchase of luxury items.

Value of Exchange Rate. If the Pound devalued, exports would become more competitive and imports more expensive. This would help to increase demand for domestic goods and services. A depreciation could cause inflation, but in the short term at least it can provide a boost to growth.

Banking Sector. The 2008 Credit crunch showed how influential the banking sector can be in determining investment and growth. If the banks lose money and no longer want to lend, it can make it very difficult for firms and consumers leading to a decline in investment.

Factors that determine Long Run Economic Growth

In the long run, economic growth is determined by factors which influence the growth of Long Run Aggregate Supply (the PPF of the economy). If there is no increase in LRAS, then a rise in AD will just be inflationary.


This graph shows an increase in LRAS and AD, leading to an increase in economic growth without inflation.


LRAS can be influenced by

Levels of infrastructure. Investment in roads, transport and communication can help firms reduce costs and expand production. Without necessary infrastructure it can be difficult for firms to be competitive in the international markets. This lack of infrastructure is often a factor holding back some developing economies.

Human Capital. Human capital is the productivity of workers. This will be determined by levels of education, training and motivation. Increased labour productivity can help firms take on more sophisticated production processes and become more efficient.

Development of Technology. In the long run development of new technology is a key factor in enabling improved productivity and higher economic growth.

Other Factors that Can Affect Growth in the Short Term.

Commodity Prices. A rise in commodity prices such as a rise in oil prices can cause a shock to growth. It causes SRAS to shift to the left leading to higher inflation and lower growth.

Political Instability. Political instability can provide a negative shock to growth.

Weather. The exceptionally cold December in UK 2010, led to a shock fall in GDP


  • Demand side factors
  • Supply side factors.

9 thoughts on “AD-AS Model Explained

  1. im a student in south africa, writing an essay on the AD-AS model with regard to the Walmart acquisition of Massmart here in SA. We are required to critically analyse the takeover with respect to the impact on South African GDP as well has introduce and explain the AS-AD model and link it to the situation..

  2. This article is very helpful and easy to read and understand. However,l could not clearly make out the labels on the graphs.So, if you could enlarge them or give an option of zooming in.

  3. I’m just gonna writte my test using this information. Thanks to the owners and developers of this site…

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