Every economy moves in waves. It expands, peaks, slips into recession, hits a trough, then recovers. This rhythm is the business cycle — the recurring rise and fall of total output over time. To explain why these waves happen, economists rely on one master diagram, the model of aggregate demand and aggregate supply.
Start with the demand side. Aggregate demand (AD) is the total quantity of goods and services everyone in the economy wants to buy at each price level — households, firms, government, and foreigners combined. Plot it and the curve slopes downward, just like an ordinary demand curve, but for three distinct reasons. The wealth effect means lower prices make the cash in your pocket worth more, so you spend more. The interest-rate effect means lower prices reduce the need to hold money, which pushes interest rates down and encourages borrowing. The exchange-rate effect means lower domestic prices make exports cheaper abroad, lifting foreign sales.
The whole AD curve can shift. Shifters of aggregate demand are anything that changes total spending at a given price level: a tax cut, a surge in consumer confidence, more government spending, a boom in a trading partner. A rightward shift means more demand at every price; a leftward shift means less.
Now the supply side, which has two faces depending on the time horizon. Short-run aggregate supply (SRAS) slopes upward. In the short run wages and some prices are sticky, so when output prices rise, firms enjoy fatter margins and produce more. But this cannot last forever.
Long-run aggregate supply (LRAS) is a vertical line. Given enough time, wages and prices fully adjust, and the economy can only produce what its workers, capital, and technology allow. This ceiling is potential output — the maximum sustainable level of production when the economy uses its resources fully and efficiently.
The gap between where the economy is and where it could be has a name. An output gap measures the distance between actual GDP and potential GDP. A negative gap means a sluggish economy with idle workers, the world of recessions. A positive gap means an overheating economy straining past its limits, which fuels inflation.
Put the pieces together and the model earns its keep. Shift AD or SRAS and you can read off what happens to output, jobs, and prices at once. Almost every macro story you will study, from a stimulus package to an oil shock, plays out on this single diagram.