IBonomicsKeynesian AD–LRAS Diagram – Demand Management and Full EmploymentSL
MacroeconomicsA Keynesian aggregate demand and long-run aggregate supply (AD–LRAS) diagram showing how real GDP and the price level interact across different phases of the economy, including spare capacity and full employment.
Curves and elements
- ad
- AD: Aggregate Demand, downward sloping due to the wealth, interest rate, and net export effects.
- lras
- LRAS: Keynesian Long-Run Aggregate Supply, horizontal when there's spare capacity, upward-sloping as resources are used up, and vertical at full employment.
- pl
- PL1: Price level at equilibrium where AD intersects LRAS.
- y
- Y1: Full employment level of output, where all resources are fully utilized.
Key explanations
- 1
In the Keynesian model, the LRAS curve is horizontal at low levels of output due to spare capacity, then upward-sloping as resources tighten, and vertical at full employment (Y1).
- 2
The AD curve slopes downward, reflecting the inverse relationship between price level and real GDP demanded.
- 3
At low levels of output, increases in AD lead to higher real GDP without inflationary pressure.
- 4
As the economy approaches Y1, increased AD results in higher prices as capacity is reached, causing inflation.
- 5
This model supports the use of demand-side policies, especially during recessions when the economy operates below full employment.
Example exam question
Using a Keynesian AD–AS diagram, explain how an increase in aggregate demand affects output and the price level when the economy is below full employment.
Show example answer
When the economy is operating below full employment, the LRAS is flat, indicating spare capacity. An increase in aggregate demand leads to a rise in real GDP without significant changes in the price level. As the economy nears full employment, further increases in AD result in inflationary pressure as the LRAS curve becomes steeper.
