3.5 Equilibrium in the Aggregate Demand-Aggregate Supply Model

Finding Short-Run Equilibrium

Short-run macroeconomic equilibrium occurs where the aggregate demand (AD) curve intersects the short-run aggregate supply (SRAS) curve, determining the equilibrium price level (PL) and real GDP. Shifts in AD or SRAS (from changes in spending, expectations, input costs, etc.) move this equilibrium, causing demand-pull or cost-push changes in output and prices.

Output Gaps

If equilibrium real GDP is below potential/full-employment GDP, a recessionary (negative) output gap exists, with high unemployment. If equilibrium GDP exceeds potential GDP, an inflationary (positive) output gap exists, with an overheated economy and rising inflation. Only at potential GDP is the economy in long-run equilibrium.

Long-Run Equilibrium & Self-Correction

Long-run equilibrium occurs where AD, SRAS, and LRAS all intersect at potential GDP. Per classical theory, the economy self-corrects: gaps cause wages/input prices to adjust, shifting SRAS until it returns to LRAS. A recessionary gap eventually shifts SRAS right (lower prices); an inflationary gap shifts SRAS left (higher wages/prices), restoring long-run equilibrium at potential GDP.

Key terms

Short-run equilibrium

The price level and real GDP where AD intersects SRAS.

Recessionary output gap

Equilibrium real GDP is below potential GDP; associated with high unemployment.

Inflationary output gap

Equilibrium real GDP exceeds potential GDP; associated with rising inflation.

Long-run equilibrium

Occurs where AD, SRAS, and LRAS all intersect at potential (full-employment) GDP.

Self-correction mechanism

Classical process where wage/price adjustments shift SRAS over time, closing output gaps and restoring equilibrium at potential GDP.

Try an AP-style question

Short-run equilibrium is where…

1. SRAS intersects LRAS
2. AD is vertical
3. AD intersects SRAS
4. AD intersects LRAS