The AS/AD model: what it is and how to shift it

The model you will be given

• The Aggregate Supply / Aggregate Demand (AS/AD) model shows the whole economy on one diagram.
• Vertical axis: the price level (PL) — the general level of prices, not the price of one good.
• Horizontal axis: real GDP (Y) — the total quantity of goods and services actually produced.
• Aggregate demand (AD) — the total spending on New Zealand-produced goods and services at each price level. It slopes downward.
• Aggregate supply (AS) — the total output firms are willing to produce at each price level. It slopes upward.
• Where the two cross is equilibrium, and it fixes both the price level and real GDP.

You are not required to know why the curves slope the way they do. The standard says explicitly that "an understanding of how to derive the AS and AD curves is not required". You need to know what moves them and what happens when they move.

What is in aggregate demand

• AD is total spending, and it has four components:

$$AD = C + I + G + (X - M)$$

• $C$ — consumption: household spending

• $I$ — investment: firms buying capital goods

• $G$ — government spending

• $X - M$ — net exports: export receipts minus import payments

• Anything that changes one of those four shifts AD.

What shifts AD, and which way

Event	Component	AD shifts
Interest rates fall	$C$ and $I$ rise	Right
A cost-of-living payment to households	$C$ rises	Right
Large-scale job losses	$C$ falls	Left
Government cuts spending	$G$ falls	Left
Export receipts rise	$X$ rises	Right
Consumer confidence falls	$C$ falls	Left
A major event brings visitors and spending to a region	$C$ rises	Right

What shifts AS, and which way

• AS shifts when the cost of production or the productive capacity of the economy changes.

Event	Effect on costs / capacity	AS shifts
Wage costs rise	Costs up	Left
Petrol and freight prices fall	Costs down	Right
A cyclone damages farms and roads	Costs up, capacity down	Left
Imported raw materials get cheaper	Costs down	Right
New technology raises productivity	Capacity up	Right
A new tax on business inputs	Costs up	Left

The four possible outcomes

Shift	Price level	Real GDP
AD right	Rises	Rises
AD left	Falls	Falls
AS left	Rises	Falls
AS right	Falls	Rises

• Notice the pattern: when AD moves, PL and Y move the same way. When AS moves, they move in opposite directions.

The two outcomes you will meet less often are worth seeing drawn, because the exam does use them — a fall in spending, and a fall in costs:

How to annotate the model so it earns marks

1. Label the original curves AS and AD, and the original equilibrium PL and Y.
2. Draw the new curve clearly to the left or right of the old one and label it AD₁ or AS₁.
3. Draw an arrow showing the direction of the shift.
4. Mark the new equilibrium and label the new PL₁ and Y₁ on the axes.
5. Only then start writing — and use those labels in your sentences.