Macroeconomies do not grow smoothly over time. Instead, economic activity fluctuates around a long-run trend. These fluctuations are known as business cycles.

Three key empirical facts characterise economic fluctuations:

Typical cyclical movements include:

These co-movements motivate the development of a model capable of explaining short-run macroeconomic dynamics.

This figure illustrates the cyclical behaviour of three important macroeconomic variables: real GDP, investment spending, and unemployment. During recessions, GDP and investment decline while unemployment increases. The shaded recession periods demonstrate that these movements occur simultaneously across the economy. Investment is particularly volatile, often falling much more sharply than output during downturns.

Earlier macroeconomic analysis focused primarily on the long run.

Key long-run concepts include:

These analyses rely on two important classical assumptions.

Under the classical dichotomy:

Implications:

In reality, monetary neutrality does not hold in the short run.

Short-run macroeconomic fluctuations occur because:

Therefore:

Changes in money supply → changes in interest rates → changes in spending → changes in output.

This temporary interaction between nominal and real variables requires a different framework.

The primary framework used to analyse short-run macroeconomic fluctuations is the Aggregate Demand–Aggregate Supply (AD–AS) model.

The model focuses on the relationship between:

This diagram illustrates the equilibrium of the macroeconomy where the aggregate demand curve intersects the aggregate supply curve. The vertical axis shows the overall price level while the horizontal axis represents real output. The equilibrium determines both the economy's output and price level simultaneously. Any shock to demand or supply shifts these curves and generates macroeconomic fluctuations.

Aggregate demand is determined by total expenditure:

Where:

Government spending is assumed fixed by policy in the short run.

The aggregate demand curve slopes downward, indicating that lower price levels increase the quantity of output demanded. This relationship arises because changes in the price level influence consumption, investment, and net exports. As prices fall, purchasing power rises and financial conditions ease, increasing spending throughout the economy.

A fall in the price level increases the real value of money balances held by households. As individuals feel wealthier, they increase consumption spending. Higher consumption increases aggregate demand.

A lower price level increases real money balances, which reduces interest rates through the money market mechanism. Lower interest rates stimulate investment spending by firms. As investment increases, aggregate demand rises.

When domestic prices fall relative to foreign prices, domestic interest rates decline. Lower interest rates cause capital outflows, leading to currency depreciation. A weaker currency increases exports and reduces imports, thereby increasing net exports.

A movement along the AD curve occurs when the price level changes.

A shift of the AD curve occurs when one of the components of expenditure changes independently of the price level.

Changes in consumption

Changes in investment

Changes in government spending

Changes in net exports

The shape of the AS curve depends on the time horizon.

Two key concepts:

In the long run, output is determined by the economy's productive capacity.

Key determinants:

Because these factors determine production capacity, the price level does not influence long-run output.

The LRAS curve is vertical at the economy's natural level of output. This reflects the idea that long-run production capacity depends only on real economic factors. Changes in the price level affect nominal variables but do not influence long-run output.

This corresponds to:

Because LRAS reflects productive capacity, it shifts when the economy's long-run fundamentals change.

Key drivers include:

Labour

Capital

Natural resources

Technology

Over time, technological progress increases the productive capacity of the economy, shifting LRAS to the right. Simultaneously, central banks typically increase the money supply, shifting aggregate demand to the right. The combined effect is rising output alongside rising prices.

This process explains why modern economies experience both economic growth and inflation over time.

In the short run, aggregate supply behaves differently.

The short-run aggregate supply curve is upward sloping, indicating that higher prices lead firms to produce more output. This occurs because wages and other input prices adjust slowly. When the price level rises but wages remain temporarily fixed, production becomes more profitable.

The next stage of the AD–AS framework will explain:

Mankiw, N. G. and Taylor, M. P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning.

Jensen, M. K. (2026) ECON1002 Introduction to Macroeconomics: Aggregate Demand and Aggregate Supply I Lecture Slides. University of Nottingham.