The aggregate demand-aggregate supply model, or AD-AS model, can help us understand business fluctuations. We’ll start exploring this model by focusing on the

The aggregate demand-aggregate supply model, or AD-AS model, can help us understand business fluctuations. We’ll start exploring this model by focusing on the aggregate demand curve.

The aggregate demand curve shows us all of the possible combinations of inflation and real growth that are consistent with a specified rate of spending growth. The dynamic quantity theory of money (M + v = P + Y) can help us understand this concept. Let’s recap the variables:

M = growth rate of the money supply

v = growth in velocity (or how quickly a dollar changes hands)

P = growth rate of prices (inflation)

Y = growth rate of real GDP

If we rewrite the equation slightly to M + v = inflation + real growth, you can think of the left side as “spending growth.”

Now let’s try out an example scenario. Suppose the growth of the money supply has been 5% and the growth in velocity has been 0%. If real GDP growth has been at 0%, you’ll get 5% + 0% = inflation + 0%. To make the sides equal, inflation must be 5%. This is one combination of inflation and real growth that is consistent with the spending growth of 5%. But there are many other possible combinations. For example, if real growth had been 3% instead of 0%, inflation would be at 2%.

Try plotting these points on a graph with inflation on the y-axis and real growth on the x-axis and connect them with a line. You’re drawing an aggregate demand curve!

Put simply, the aggregate demand curve connects all of the points on a graph that show us all of the possible combinations of inflation and real growth that are consistent with spending growth.

You can think about spending growth another way, too. It’s actually the equivalent of nominal GDP growth. If nominal GDP growth is 5%, an AD curve shows all of the possible combinations of inflation and real GDP growth that add up to 5% nominal GDP growth. Likewise, if nominal GDP growth is 7%, the AD curve will show all of the possible combinations of inflation and real GDP growth that add up to 7%, and so on. Increases in the growth rate of nominal GDP shift the aggregate demand curve outwards, whereas decreases shift it inwards.

Up next, we’ll combine our new knowledge on the AD curve with the long-run aggregate supply curve.

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