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.

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 domestic 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 no 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. At some point, however, even higher prices will not attract additional output. The economy has reached its production capacity.

The economy is initially at the full employment level of real GDP, labeled Q, 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. The button labeled Reference Lines will toggle on or off the previous locations of the AD and AS curves and the corresponding price and GDP levels. Hitting Reset will restore the economy to full employment GDP and a stable price level.

1. Starting from full employment, what will be the impact of an increase in desired consumption expenditures?
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2. Suppose the economy is operating in the vertical range of AS and the government lowers taxes. What effect will this policy have on real GDP and the price level?
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3. Suppose the economy is in a deep recession. The government increases the money supply, thereby reducing interest rates. Will this policy increase real GDP? Will it affect the price level?
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4. Suppose the economy is operating at full employment and prices are stable. All else equal, will an increase in wages and salaries increase the aggregate price level?
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5. The late 1990s were a period of dramatically rising stock values and rising labor productivity. Real GDP increased, yet prices remained relatively stable. How might this be explained by the AD-AS model?
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