Equilibrium in the AD–AS Model: Study Guide (Macroeconomics 3.5)

Three curves on one graph

You now have all three curves of the aggregate demand–aggregate supply (AD–AS) model:

• AD (Topic 3.1): the total real output that households, firms, the government and the rest of the world plan to buy at each price level. It slopes down.
• SRAS (Topic 3.3): the total real output firms supply at each price level while some input prices, especially nominal wages, are sticky. It slopes up.
• LRAS (Topic 3.4): a vertical line at full-employment output (Yf), where unemployment equals the natural rate.

All three share the same axes: price level on the vertical axis and real GDP (real output) on the horizontal axis. In this topic you put them together to answer two questions. Where does the economy settle in the short run? And is that position one it can keep in the long run?

Short-run equilibrium

Short-run equilibrium is the price level and real output at which the aggregate quantity of output demanded equals the aggregate quantity supplied. On a graph, it is the point where the AD and SRAS curves cross. Call the equilibrium price level PL₁ and the equilibrium real output Y₁.

Why does the economy move to this point? Think about what happens at any other price level.

• Price level above equilibrium. Firms supply more than buyers want to purchase. Unsold goods pile up, so firms’ inventories rise by more than they planned. Firms respond by cutting prices and producing less. The price level and output fall towards equilibrium.
• Price level below equilibrium. Buyers want more than firms are supplying. Firms sell more than they produce, so inventories fall unexpectedly. Firms raise prices and increase output. The price level and output rise towards equilibrium.

Only at the crossing point do firms sell exactly what they produce, so there is no pressure for the price level or output to change. This is the same logic as equilibrium in a single market (Unit 1), but here it applies to all goods and services at once, using the price level and real GDP.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). The figures continue the Topic 3.3 and 3.4 study guides: a labour force of 25.0 million, a natural rate of unemployment of 5.0%, and full-employment output Yf = VD 840 billion. Valdoria’s SRAS schedule is the one from Topic 3.3. All data are fictional.

Price level (index)	96	100	104	108	112
AD: real GDP demanded (VD billion)	880	860	840	820	800
SRAS: real GDP supplied (VD billion)	760	800	840	880	920

As in Topic 3.3, every VD 40 billion of real output needs 0.25 million workers, so each VD 40 billion change in output moves the unemployment rate by 1.0 percentage point. At VD 840 billion, 23.75 million people are employed and unemployment is 5.0%.

Worked example 1: finding equilibrium from schedules

Question. Use the table. (a) Find Valdoria’s short-run equilibrium price level and real output. (b) At a price level of 108, compare the quantities demanded and supplied, and explain what happens next. (c) Do the same at a price level of 100. (d) Is Valdoria in long-run equilibrium? Explain.

(a) Look for the price level where the two rows match. At 104, real GDP demanded = real GDP supplied = VD 840 billion. So PL₁ = 104 and Y₁ = VD 840 billion.

(b) At 108, firms supply VD 880 billion but buyers want only VD 820 billion. There is a surplus of 880 − 820 = VD 60 billion. Inventories build up beyond what firms planned, so firms cut prices and output. The price level falls back towards 104.

(c) At 100, buyers want VD 860 billion but firms supply only VD 800 billion. There is a shortage of 860 − 800 = VD 60 billion. Inventories run down, so firms raise prices and produce more. The price level rises towards 104.

(d) Yes. Equilibrium output (VD 840 billion) equals Yf, so AD and SRAS cross on the LRAS curve. Unemployment is 5.0%, equal to the natural rate, and cyclical unemployment is zero.

Check. A table only shows some price levels. If the two rows never match exactly, the equilibrium lies between the two price levels where the gap between demand and supply changes sign.

Long-run equilibrium

Long-run equilibrium happens when the AD and SRAS curves cross on the LRAS curve. Then three things are true at once:

1. Aggregate quantity demanded equals aggregate quantity supplied (AD = SRAS).
2. Real output equals full-employment output (Y₁ = Yf).
3. Unemployment equals the natural rate, so cyclical unemployment is zero.

Figure 1 is a picture of long-run equilibrium. Notice that all three curves pass through the same point. When you are asked to draw an economy “in long-run equilibrium”, that is what the examiner looks for.

Short-run equilibrium only needs condition 1. So every long-run equilibrium is also a short-run equilibrium, but a short-run equilibrium need not be a long-run one.

Output gaps

The output gap is the difference between actual real output and full-employment (potential) output:

Output gap = actual real GDP − full-employment real GDP (Yf)

It can also be given as a percentage of Yf: gap ÷ Yf × 100. Short-run equilibrium can be in one of three places.

Where AD and SRAS cross	Output gap	Unemployment	Also called
To the left of LRAS (Y₁ < Yf)	Negative	Above the natural rate (cyclical unemployment > 0)	Recessionary gap
On LRAS (Y₁ = Yf)	Zero	Equal to the natural rate	Long-run equilibrium
To the right of LRAS (Y₁ > Yf)	Positive	Below the natural rate	Inflationary gap

Why the names? A negative gap means idle workers and machines: the economy is producing less than it could, as in a recession. A positive gap means firms are using resources beyond their sustainable level (overtime, extra shifts), and unemployment is unusually low. Workers are hard to find, so there is upward pressure on wages and prices. That is why it is called inflationary.

Worked example 2: identifying output gaps

Question. In two other years, Valdoria’s SRAS schedule was the same as above, but its AD schedule was different. Yf is still VD 840 billion and the natural rate is 5.0%.

Price level (index)	98	100	102	104	106	108
SRAS (VD billion)	780	800	820	840	860	880
AD in Year 2 (VD billion)	840	830	820	810	800	790
AD in Year 3 (VD billion)	900	890	880	870	860	850

For each year: (a) find short-run equilibrium; (b) find the output gap in VD billion and as a percentage of Yf, and name it; (c) find the unemployment rate and the number of people cyclically unemployed; (d) say whether Valdoria was in long-run equilibrium.

Year 2.

(a) AD = SRAS = VD 820 billion at a price level of 102. So PL₁ = 102, Y₁ = VD 820 billion.

(b) Gap = 820 − 840 = −VD 20 billion. As a percentage: −20 ÷ 840 × 100 = −2.38%. Output is below Yf, so this is a negative (recessionary) gap.

(c) Output is VD 20 billion below Yf. Each VD 40 billion is 0.25 million jobs, so VD 20 billion is 0.125 million jobs. Employment = 23.75 − 0.125 = 23.625 million. Unemployed = 25.0 − 23.625 = 1.375 million. Unemployment rate = 1.375 ÷ 25.0 × 100 = 5.50%. That is 0.50 percentage points above the natural rate, so 0.125 million people are cyclically unemployed.

(d) No. AD and SRAS cross to the left of LRAS.

Year 3.

(a) AD = SRAS = VD 860 billion at a price level of 106. So PL₁ = 106, Y₁ = VD 860 billion.

(b) Gap = 860 − 840 = +VD 20 billion, or 20 ÷ 840 × 100 = +2.38% of Yf. Output is above Yf: a positive (inflationary) gap.

(c) Employment = 23.75 + 0.125 = 23.875 million. Unemployed = 1.125 million. Unemployment rate = 1.125 ÷ 25.0 × 100 = 4.50%, which is 0.50 points below the natural rate. Cyclical unemployment is negative: 0.125 million more people are working than at full employment.

(d) No. AD and SRAS cross to the right of LRAS. This position cannot be sustained.

Check. In both years AD equals SRAS, so both are genuine short-run equilibria. Being “in equilibrium” does not mean being at full employment. The sign of the gap and the unemployment rate always agree: a negative gap goes with unemployment above the natural rate, a positive gap with unemployment below it.

How to draw an AD–AS equilibrium graph

Graph points are easy to lose. Follow this routine every time.

1. Label the axes Price level (vertical) and Real GDP or real output (horizontal). Never “price” and “quantity”.
2. Draw a downward-sloping AD, an upward-sloping SRAS and a vertical LRAS, and label each one.
3. Mark the point where AD and SRAS cross. Draw dotted lines to both axes and label them PL₁ and Y₁.
4. Label Yf where LRAS meets the horizontal axis.
5. Check the question: if it says long-run equilibrium, all three curves must cross at one point (Y₁ = Yf). If it describes a recession or high unemployment, put the crossing point to the left of LRAS. If it describes unemployment below the natural rate, put it to the right.

Common misconceptions

• “Equilibrium means full employment.” AD = SRAS is short-run equilibrium, which can be at, above or below Yf. Long-run equilibrium also needs the crossing point to be on LRAS.
• “Short-run equilibrium is where SRAS meets LRAS.” It is where AD meets SRAS. LRAS only tells you whether that point is also a long-run equilibrium.
• “A surplus of output makes the AD curve shift.” At a price level above equilibrium, the economy moves along the curves as the price level falls. Neither curve shifts.
• “A positive output gap is good, because output is high.” Output above Yf is not sustainable. It comes with unemployment below the natural rate and upward pressure on wages and prices.
• Getting the sign of the gap backwards. Gap = actual − potential. Output below Yf gives a negative number.
• “In a recessionary gap, unemployment is below the natural rate.” It is above the natural rate; cyclical unemployment is positive.
• Drawing long-run equilibrium with LRAS missing or off the crossing point. All three curves must pass through the same point.
• Mislabelling axes. Use price level and real GDP, not price and quantity, and never put nominal GDP on the horizontal axis.

Where this leads

In Topic 3.6 you will shift AD and SRAS to see how shocks move the economy away from long-run equilibrium in the short run, and how this creates demand-pull and cost-push inflation: continue with the changes in the AD–AS model in the short run study guide. Topic 3.7 then shows how flexible wages and prices close an output gap in the long run. If LRAS and Yf are not yet secure, go back to Topic 3.4.

Now try the practice questions, then use the revision notes and the checklist to consolidate.