Unit 3 · Topic 3.5

Equilibrium in the Aggregate Demand-Aggregate Supply (AD-AS) Model

The AD-AS model shows the price level and real GDP where AD meets SRAS (short-run equilibrium).

Practice 1: Principles and ModelsPractice 2: InterpretationPractice 4: Graphing and Visuals

Part 1 · Hook

Why this matters

Two economies report the same real GDP growth this year. In one, factories have idle shifts and job ads are scarce. In the other, firms are paying overtime and still cannot find workers. To tell them apart you need more than output: you need to know where output stands against what the economy can produce at full employment. The AD-AS model puts both on one graph.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. What is a recessionary gap?

  1. Real GDP below potential output
  2. Real GDP above potential output
  3. A fall in the price level
  4. A rise in the unemployment rate to zero
Show the answer

A recessionary (negative) gap is real GDP below potential (full-employment) output.

  • Correct: Real GDP below potential output:
  • Real GDP above potential output:
  • A fall in the price level:
  • A rise in the unemployment rate to zero:

2. Where does LRAS stand?

  1. Vertical at full-employment output
  2. Sloping up through full-employment output
  3. Horizontal at the current price level
  4. Wherever AD crosses SRAS
Show the answer

In the long run output is at potential at any price level: LRAS is vertical at YF.

  • Correct: Vertical at full-employment output:
  • Sloping up through full-employment output:
  • Horizontal at the current price level:
  • Wherever AD crosses SRAS:

Part 4 · See it

See it first

Two AD-AS graphs with LRAS at full-employment output YF. Left: AD crosses SRAS at Y1, to the left of YF, a recessionary gap. Right: AD crosses SRAS at Y1, to the right of YF, an inflationary gap.
Left: AD meets SRAS left of LRAS, a recessionary gap. Right: AD meets SRAS right of LRAS, an inflationary gap. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. AD crosses SRASthe short-run price level (PL1) and real GDP (Y1) are set
  2. Y1 is to the left of LRASa recessionary gap: unemployment above the natural rate
  3. Y1 is to the right of LRASan inflationary gap: unemployment below the natural rate
  4. AD and SRAS cross on LRASlong-run equilibrium at full employment

Part 6 · Key ideas

Key ideas

  • The AD-AS model puts AD, SRAS and LRAS on one graph: Price level (PL) up the side, Real GDP (Y) along the bottom.
  • Short-run equilibrium is where AD crosses SRAS; label it PL1 and Y1 with dashed lines to both axes.
  • Long-run equilibrium is where AD and SRAS cross on LRAS: output at full employment (YF), unemployment at the natural rate.
  • Y1 < YF: a recessionary gap, unemployment above the natural rate. Y1 > YF: an inflationary gap, unemployment below it.

Part 7 · Misconception

A common mistake

The wrong idea: Wherever AD crosses SRAS, the economy is at full employment, because that is the equilibrium.

What actually happens: AD crossing SRAS is only a short-run equilibrium. Output is at full employment only when that crossing lies on LRAS.

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

Graph

The AD-AS graph for Country D

Real GDPPrice levelADSRASLRASYPL

1. According to the graph, what kind of gap does Country D have?

  1. An inflationary gap, because AD and SRAS cross to the left of LRAS
  2. No gap, because AD and SRAS cross each other
  3. No gap, because LRAS passes through the AD curve
  4. A recessionary gap, because AD and SRAS cross to the left of LRAS
Show the answer

In the graph, AD meets SRAS at an output to the left of LRAS: real GDP is below potential, a recessionary gap.

  • An inflationary gap, because AD and SRAS cross to the left of LRAS: Left of LRAS means output below potential, which is a recessionary gap.
  • No gap, because AD and SRAS cross each other: They cross, which sets short-run output, but not on LRAS, so there is a gap.
  • No gap, because LRAS passes through the AD curve: LRAS crosses AD on any such graph; what matters is whether AD and SRAS meet on LRAS. Here they meet to its left.
  • Correct: A recessionary gap, because AD and SRAS cross to the left of LRAS: Right: short-run output is below full-employment output.

2. According to the graph, how does Country D's unemployment rate compare with its natural rate?

  1. It is above the natural rate, because output is below full employment
  2. It is below the natural rate, because output is below full employment
  3. It equals the natural rate, because SRAS crosses AD
  4. There is no way to compare them, as unemployment is not on the graph
Show the answer

Output below full employment means unemployment above the natural rate: there is cyclical unemployment.

  • Correct: It is above the natural rate, because output is below full employment: Right: producing less than potential needs fewer workers, so cyclical unemployment is positive.
  • It is below the natural rate, because output is below full employment: Lower output means fewer jobs, so unemployment is above, not below, the natural rate.
  • It equals the natural rate, because SRAS crosses AD: Unemployment equals the natural rate only at full-employment output, on LRAS.
  • There is no way to compare them, as unemployment is not on the graph: Output tells you: below YF, unemployment is above the natural rate.

3. Which statement about Country D's position in the graph is correct?

  1. It is a long-run equilibrium, because AD equals SRAS
  2. It is a short-run equilibrium but not a long-run equilibrium
  3. It is not an equilibrium, because firms want to produce more
  4. It is both a short-run and a long-run equilibrium at the same time
Show the answer

Where AD meets SRAS is a short-run equilibrium. It is also a long-run equilibrium only if that point is on LRAS.

  • It is a long-run equilibrium, because AD equals SRAS: A long-run equilibrium also needs output on LRAS, at full employment.
  • Correct: It is a short-run equilibrium but not a long-run equilibrium: Right: planned spending equals output supplied at SRAS, but output is off LRAS.
  • It is not an equilibrium, because firms want to produce more: At the AD-SRAS crossing, the output firms supply equals what buyers plan to buy.
  • It is both a short-run and a long-run equilibrium at the same time: Output is below YF, so it is not on LRAS.

4. Label the axes and the three curves of this AD-AS graph.

???1?2?3

Work on the graph (it needs JavaScript), then check.

Show the answer

Vertical axis: Price level. Horizontal axis: Real GDP. AD slopes down, SRAS slopes up, LRAS is vertical at full-employment output.

  • Key: see the explanation

5. The economy starts in long-run equilibrium. Households and firms grow pessimistic and cut their spending. Shift the right curve and mark the new short-run equilibrium.

Real GDPPrice levelADSRASLRASYPL

Work on the graph (it needs JavaScript), then check.

Show the answer

Less spending shifts AD left. The new short-run equilibrium is left of LRAS, with a lower price level and lower real GDP: a recessionary gap.

  • Key: aggregate demand shifts left

6. What defines short-run equilibrium in the AD-AS model?

  1. The price level and real GDP where AD crosses LRAS
  2. Real GDP at full employment, whatever the price level
  3. The price level and real GDP where AD crosses SRAS
  4. The price level at which unemployment is zero
Show the answer

Short-run equilibrium: where AD meets SRAS. Long-run equilibrium: where AD, SRAS and LRAS all meet.

  • The price level and real GDP where AD crosses LRAS: AD crossing LRAS gives the long-run outcome only when SRAS passes through the same point.
  • Real GDP at full employment, whatever the price level: That is where LRAS stands. Short-run output can differ from it.
  • Correct: The price level and real GDP where AD crosses SRAS: Right: there, planned spending equals the output firms supply.
  • The price level at which unemployment is zero: Even at full employment there is natural unemployment; equilibrium is where AD meets SRAS.

Part 9 · Summary

Summary

The AD-AS model shows the price level and real GDP where AD meets SRAS (short-run equilibrium). Comparing that output with LRAS shows the gap: left of LRAS is a recessionary gap with unemployment above the natural rate, right of LRAS an inflationary gap with unemployment below it. Long-run equilibrium is where all three curves meet.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic