Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- After a shock, the short-run equilibrium can be off LRAS: real GDP is below or above full-employment output (Yf).
- With no government policy, nominal wages and other input prices adjust when contracts are renewed. This shifts SRAS until real GDP is back at Yf and unemployment is back at the natural rate.
- Recessionary gap (output < Yf, unemployment above natural rate): nominal wages fall → SRAS shifts right → price level falls → output rises to Yf.
- Inflationary gap (output > Yf, unemployment below natural rate): nominal wages rise → SRAS shifts left → price level rises → output falls to Yf.
- A shift of LRAS means full-employment output has changed. Rightward = economic growth.
Key relationships
| Shock, no policy | Long run compared with before the shock |
|---|---|
| AD decreases | Lower price level; real GDP = Yf; natural rate of unemployment |
| AD increases | Higher price level; real GDP = Yf; natural rate of unemployment |
| Temporary SRAS decrease or increase | Back to the original price level, Yf and natural rate |
| LRAS shifts right | Higher Yf: the economy now returns to a larger output |
| Where to look | What it tells you |
|---|---|
| AD crosses SRAS | Short-run equilibrium |
| AD crosses LRAS | Long-run equilibrium price level |
| Horizontal gap between SRAS and AD at the long-run price level | Size of the SRAS shift needed |
Assumptions
- The government takes no action and no other shock arrives.
- Resources and technology are fixed, so LRAS does not move, unless a question says otherwise.
- Wages and prices are fully flexible in the long run. The model gives no fixed time for this; it can be slow.
Mistakes to avoid
- Shifting AD back instead of SRAS.
- Wrong wage direction: high unemployment lowers nominal wages; a labour shortage raises them.
- Stopping at the short run: the long-run point is on LRAS.
- Saying the price level returns to its old value after an AD shock. It ends lower (AD fell) or higher (AD rose).
- Moving LRAS to meet the economy. Only resources and technology move LRAS.
- Equating the SRAS shift with the output gap. The shift is usually larger.
Quick self-check
- Real GDP is VD 820 billion and Yf is VD 840 billion. Name the gap and the direction SRAS shifts without policy. (Recessionary gap of VD 20 billion; SRAS shifts right.)
- AD rose last year from long-run equilibrium. Compared with before, what is the long-run unemployment rate? (The same: the natural rate.)
- A drought ends after one year. Where does the economy end up without policy? (At its original price level and Yf.)
Next: practice questions.