Editing Aggregate demand (section)

===Aggregate demand-aggregate supply model===
{{Main|AD–AS model}}

Sometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve that ''looks'' like that in a typical [[Marshallian demand|Marshallian]] [[supply and demand]] diagram.

[[File:AS + AD graph.svg|right|thumb|300px|Aggregate supply/demand graph]]

Thus, we could refer to an "aggregate quantity demanded" (<math>Y^d = C + I_p + G + NX</math> in real or inflation-corrected terms) at any given aggregate average price level (such as the [[GDP deflator]]), <math>P</math>.

In these diagrams, typically the <math>Y^d</math> rises as the average price level (<math>P</math>) falls, as with the <math>AD</math> line in the diagram. The main theoretical reason for this is that if the nominal [[money]] supply ('''M<sup>s</sup>''') is constant, a falling <math>P</math> implies that the [[Real vs. nominal in economics|real]] money supply (<math>\frac{M^s}{P}</math>)rises, encouraging lower [[interest rate]]s and higher spending. This is often called the "[[Keynes effect]]". 
                   
Carefully using ideas from the [[theory]] of [[supply and demand]], [[aggregate supply]] can help determine the extent to which increases in aggregate demand lead to increases in real [[output (economics)|output]] or instead to increases in prices ([[inflation]]). In the diagram, an increase in any of the components of <math>AD</math> (at any given <math>P</math>) shifts the <math>AD</math> curve to the right. This increases both the level of real production (<math>Y</math>) and the average price level (<math>P</math>).

But different levels of economic activity imply different mixtures of output and price increases. As shown, with very low levels of [[real vs. nominal in economics|real]] [[gross domestic product]] and thus large amounts of unemployed resources, most economists of the [[Keynesian economics|Keynesian school]] suggest that most of the change would be in the form of output and employment increases. As the economy gets close to [[potential output]] (<math>Y^*</math>), we would see more and more price increases rather than output increases as <math>AD</math> increases.

Beyond <math>Y^*</math>, this gets more intense, so that price increases dominate. Worse, output levels greater than <math>Y^*</math> cannot be sustained for long. The <math>AS</math> is a ''short-term'' relationship here. If the economy persists in operating above potential, the <math>AS</math> curve will shift to the left, making the increases in real output transitory.

At low levels of <math>Y</math>, the world is more complicated. First, most modern industrial economies experience few if any fall in prices. So the <math>AS</math> curve is unlikely to shift down or to the right. Second, when they do suffer price cuts (as in Japan), it can lead to disastrous [[deflation (economics)|deflation]].