3.5 - Equilibrium in the AD–AS Model

The aggregate demand-aggregate supply model

The aggregate demand-aggregate supply (AD-AS) model is a framework economists use to show the relationship between the overall price level in an economy and the total output of goods and services. This model helps explain how changes in demand or supply can affect output, employment, and prices. It includes three key curves that represent different aspects of the economy.

Key components of the AD-AS model

• Aggregate demand (AD) curve - This curve shows the total quantity of goods and services demanded across the economy at different price levels. It slopes downward because higher prices reduce purchasing power and increase interest rates, leading to less spending.
• Short-run aggregate supply (SRAS) curve - This curve represents the total quantity of goods and services that firms are willing to supply in the short run at different price levels. It slopes upward because higher prices encourage firms to produce more, assuming some costs like wages remain fixed temporarily.
• Long-run aggregate supply (LRAS) curve - This vertical curve indicates the economy's potential output when all resources are fully employed, regardless of the price level. It reflects the full-employment level of real output, where the economy operates at its maximum sustainable capacity without accelerating inflation.

These curves are typically graphed with the price level on the vertical axis and real output (often measured as real gross domestic product, or real GDP) on the horizontal axis. The AD-AS model illustrates how the economy responds to various shocks, such as changes in consumer spending or production costs.

Short-run equilibrium in the AD-AS model

Short-run equilibrium occurs when the economy's total demand matches its total supply in the near term, before all adjustments like wage changes can take effect. This balance determines the current price level and output level.

At short-run equilibrium, the aggregate quantity of output demanded equals the aggregate quantity of output supplied. This point is found at the intersection of the AD curve and the SRAS curve on a graph.

Graphing short-run equilibrium

In the diagram below the downward-sloping AD curve crosses the upward-sloping SRAS curve, and dashed guides from that intersection give the equilibrium price level PL₁ and the equilibrium output Y₁.

This equilibrium can shift if there are macroeconomic shocks, such as a sudden increase in oil prices that moves the SRAS curve leftward, raising prices and reducing output.

Long-run equilibrium in the AD-AS model

Long-run equilibrium represents a state where the economy has fully adjusted to any short-term changes, operating at its full potential without unsustainable pressures on prices or employment. This occurs when resources like labor and capital are used efficiently.

In the long run, equilibrium is achieved when the AD curve and SRAS curve intersect exactly on the LRAS curve. This intersection point indicates the full-employment level of real output, where the economy produces at its maximum sustainable level without causing accelerating inflation.

Graphing long-run equilibrium

In the diagram below the AD and SRAS curves cross exactly on the vertical LRAS curve. The price level at that point is PL₁ and the output is the full-employment output Y_F, which is where LRAS stands.

Over time, if the short-run equilibrium deviates from the LRAS, factors like wage adjustments will shift the SRAS curve until it realigns with the LRAS, restoring long-run balance.

Output gaps and their economic implications

An output gap measures the difference between the economy's actual output in the short run and its potential output at full employment. These gaps arise when short-run equilibrium does not align with the LRAS curve, signaling imbalances that can lead to inflation or unemployment.

Types of output gaps

• Positive (inflationary) output gap - This occurs when short-run equilibrium output exceeds the full-employment level (Y₁ > Y_F). As a result, demand outpaces sustainable supply, causing upward pressure on prices and potential overheating in the economy.
• Negative (recessionary) output gap - This happens when short-run equilibrium output falls below the full-employment level (Y₁ < Y_F). Consequently, resources like labor are underutilized, leading to higher unemployment and slower economic growth.

Graphing output gaps

To find an output gap, plot the AD, SRAS and LRAS curves, find the short-run equilibrium where AD crosses SRAS, and compare its output with the LRAS.

In the first diagram below, AD crosses SRAS to the left of LRAS. Short-run output Y₁ falls short of the full-employment output Y_F, and the distance between them is the recessionary gap.

In the second, AD crosses SRAS to the right of LRAS. Short-run output Y₁ exceeds Y_F, and the distance between them is the inflationary gap.

Output gaps are temporary, as the economy tends to self-correct toward long-run equilibrium through adjustments in wages and prices. For example, a recessionary gap might prompt falling wages, shifting SRAS rightward to close the gap.