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Lesson summary: equilibrium in the AD-AS model

AP.MACRO:
MOD‑2 (EU)
,
MOD‑2.G (LO)
,
MOD‑2.G.1 (EK)
,
MOD‑2.G.2 (EK)
,
MOD‑2.G.3 (EK)
In this lesson summary review and remind yourself of the key terms and graphs related to a short-run macroeconomic equilibrium. Topics include how to model a short-run macroeconomic equilibrium graphically as well as the relationship between short-run and long-run equilibrium and the business cycle.

Lesson Summary

So far we have learned to measure real GDP, but how do we end up with that real GDP? Of all of the different amounts of national income and price levels that might exist, how do we gravitate toward the one that gets measured each year as real GDP?
In short, it is the interaction of the buyers and producers of all output that determines both the national income (real GDP) and the price level. In other words, the intersection of aggregate demand (AD) and short-run aggregate supply (SRAS) determines the short-run equilibrium output and price level.
Once we have a short-run equilibrium output, we can then compare it to the full employment output to figure out where in the business cycle we are. If current real GDP is less than full employment output, an economy is in a recession. If current real GDP is higher than full employment output, an economy is experiencing a boom. If the current output is equal to the full employment output, then we say that the economy is in long-run equilibrium. Output isn’t too low, or too high. It’s just right.

Key terms

Key termdefinition
AD-AS modela graphical model used to understand economic fluctuations, which contains aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS)
short-run macroeconomic equilibriumwhen the quantity of aggregate output supplied is equal to the quantity of aggregate output demanded; graphically, this is the price level and real GDP associated with the intersection of the SRAS and AD curves.
short-run equilibrium price levelthe aggregate price level that will exist when an economy is in short-run equilibrium; remember that the price level is a measure such as the CPI.
short-run equilibrium outputthe quantity of aggregate output produced in the short-run macroeconomic equilibrium; this is the amount of real GDP that will exist when AD intersects SRAS.
recessionary gap(sometimes called a negative output gap) when the current output is less than potential output
inflationary gap(sometimes called a positive output gap) when the current output is greater than potential output
long-run macroeconomic equilibriumwhen the current output is equal to potential output; graphically, this would be the price level and real GDP associated with the intersection of AD, SRAS, and LRAS.

Key Takeaways

Short-run equilibrium

An economy is in short-run equilibrium when the aggregate amount of output demanded is equal to the aggregate amount of output supplied. In the AD-AS model, you can find the short-run equilibrium by finding the point where AD intersects SRAS. The equilibrium consists of the equilibrium price level and the equilibrium output. A good practice is to think of the short-run equilibrium as “how much real GDP is this economy creating right now, and what is the CPI an economy has right now?”
In our analysis of markets, an economy in disequilibrium results in price adjusting until the market finds an equilibrium. The same general idea applies to a short-run macroeconomic equilibrium as well, but with a minor modification. If the amount of output demanded is greater than the amount of output produced, people chase after the limited goods available and drive up the price level. In response to the increase in the price level, producers create more goods and services. This continues until the amount of aggregate production equals the amount of aggregate demand.
Suppose the aggregate output demanded and the aggregate output supplied at different price levels are as shown in the table below:
Real output demandedprice levelreal output supplied
dollar sign, 400125dollar sign, 500
dollar sign, 430120dollar sign, 480
dollar sign, 460115dollar sign, 460
dollar sign, 490110dollar sign, 440
If the price level in this economy is only 110, for example, aggregate demand will exceed aggregate supply, leading to shortages. Buyers will compete with each other to get output, driving the price level up. Higher price levels will induce producers to increase their output. This price level adjustment will keep occurring until there is no incentive to change. After all, the definition of an equilibrium is “no tendency to change”!
The opposite happens when the amount of output demanded is less than the amount produced. The amount of output supplied will be greater than aggregate demand. Prices will begin to fall to eliminate the surplus output. As prices fall, the amount of aggregate demand increases and the economy returns to equilibrium.

Long-run equilibrium

There is an important distinction between a short-run equilibrium and a long-run equilibrium. The short-run equilibrium says that this price adjustment hasn’t happened yet, and so it just provides the real GDP that exists right now.
Remember how the LRAS curve represented the idea that all prices have fully adjusted? Well, a long-run equilibrium means that everything that can change has changed. In other words, the current output is the same as the full employment output because all prices have fully adjusted.
When the current output that is generated by the interaction of SRAS and AD is identical to the full employment output, all prices have adjusted in the economy. Graphically, this looks like the intersection of all three of our curves in the AD-AS model.

Positive and negative gaps in the AD-AS model

One of the goals of macroeconomics is to explain why business cycles occur. We can use the AD-AS model to capture the different stages of the business cycle. The AD-AS model helps compare our current output (the short-run equilibrium) to the full employment output. The difference between current output and the full employment output is called a “gap”.
Negative output gaps mean that an economy is producing less than full employment, while positive output gaps mean that an economy is producing more than full employment output. Positive output gaps are sometimes called “inflationary gaps” because producing more than full employment is usually associated with a higher price level.

Key Graphs

Short-run equilibrium - Recession

Figure 1: An AD-AS model illustrating a short-run equilibrium with a negative (recession) output gap.
The short-run equilibrium is the point where SRAS and AD intersect, which yields Y, start subscript, 1, end subscript as the current output and P, L, start subscript, 1, end subscript as the current price level. Notice that Y, start subscript, 1, end subscript is less than Y, start subscript, f, end subscript. This means that the economy is producing less than full employment output and is in a recession (another way of saying this would be that the economy is experiencing a negative output gap).
A gap is a space, after all. When we see a graph of the AD-AS model, and the space between Y, start subscript, 1, end subscript and Y, start subscript, f, end subscript is to the left of Y, start subscript, f, end subscript, that space represents producing less than full employment output.
Figure 2: An AD-AS model illustrating a short-run equilibrium with a positive (inflationary) output gap.
The short-run equilibrium is the point where SRAS and AD intersect, which yields Y, start subscript, 1, end subscript as the current output and P, L, start subscript, 1, end subscript as the current price level. Notice that Y, start subscript, 1, end subscript is more than Y, start subscript, f, end subscript, which means that the economy is producing more than full employment output and has an inflationary gap (another way of saying this would be that the economy is experiencing a positive output gap).

Long-run equilibrium

Figure 3: An AD-AS model illustrating a long-run equiibrium
The short-run equilibrium is the point where SRAS and AD intersect, which yields Y, start subscript, 1, end subscript as the current output and P, L, start subscript, 1, end subscript as the current price level. Notice two things about this. First, Y, start subscript, 1, end subscript is equal to Y, start subscript, f, end subscript, which means that the economy is producing exactly its full employment output and is in long-run equilibrium. Second, LRAS is always vertical at this point, so the long-run equilibrium is where all three of these curves intersect.
That’s really the way to think about a long-run equilibrium—its really two equilibrium. The short-run equilibrium (where AD is equal to SRAS) is what the country is currently producing (Y, start subscript, 1, end subscript). The definition of the long-run in economics is long enough for all prices to adjust. When all prices have adjusted, the short-run output will also be the full employment output.

Tips for graphing

When you’re given a problem asking you to graph an economy using the AD-AS model, start with the short-run equilibrium. We know that the economy will definitely reach a short-run equilibrium, so it is a natural place to start!
Once you have a short-run equilibrium output and price level, then decide where to put our LRAS curve and full employment output. This will depend on which part of the business cycle the economy is in: right of the short-run equilibrium for recession, left of the short-run equilibrium for expansion, right through the middle of the short-run equilibrium for long-run equilibrium. Use the mathematical symbols <,>, and = to help you remind yourself of the relationship between current output and potential output.

Common Misperceptions

  • Isn’t it impossible to exceed your potential? No! The best analogy to this is staying up all night to study for an exam or finish a project. It might be possible to exceed your sustainable production occasionally, but the key phrase here is “sustainable production.” It wouldn’t be possible to keep up that kind of activity for very long. That’s the idea behind the positive output gap. You can think of this at the economy-wide level as factories running 24 hours a day and workers taking a lot of extra hours at work.
  • A common misperception is that you can label an equilibrium as the intersection point itself. But this is not the case . . . you need to label the equilibrium price level and equilibrium output on the axes. This is a convention in economics, and its important to follow that convention. So, when you label PL and current output, make sure you indicate these by making a dotted line from the intersection of AD and SRAS to the axes, and then put your labels on the axes.
  • Some people think that these models are all independent of each other, but that is not the case. Every model in macroeconomics is closely intertwined with every other model. We can summarize the relationship between our AD-AS model and all of the models we have encountered so far (the business cycle and PPC model) as given in the table below:
    Recession (negative output gap)Inflationary gap (positive output gap)Long-run equilibrium
    How it looks in the AD-AS modelLRAS to the right of current outputLRAS to the left of current outputLRAS equals current output
    MathematicallyY, start subscript, 1, end subscript, is less than, Y, start subscript, f, end subscriptY, start subscript, 1, end subscript, is greater than, Y, start subscript, f, end subscriptY, start subscript, 1, end subscript, equals, Y, start subscript, f, end subscript
    UnemploymentU, R, is greater than, U, R, start subscript, N, end subscriptU, R, is less than, U, R, start subscript, N, end subscriptU, R, equals, U, R, start subscript, N, end subscript
    PPCpoint inside PPCpoint outside PPCpoint on PPC

Discussion questions

  • What is the difference between a short-run equilibrium and a long-run equilibrium?
  • Assume the economy of Johnsrudia is currently operating at short-run equilibrium and producing dollar sign, 350 million in real GDP and a CPI of 190. However, the full employment rate of output in Johnsrudia is dollar sign, 300 million. Draw a correctly labeled graph of the AD-AS model that reflects this information.
  • Assume the economy of Maxistan is experiencing an unemployment rate that is higher than the natural rate of unemployment. Draw a correctly labeled graph of the long-run aggregate supply, short-run aggregate supply, and aggregate demand and show each of the following:
(i) Current equilibrium output and price level, labeled as Y, start subscript, 1, end subscript and P, L, start subscript, 1, end subscript, and
(ii) full employment output, labeled as Y, start subscript, f, end subscript.
Then, draw a PPC for the economy of Maxistan showing its current output labeled Y, start subscript, 1, end subscript.
  • Fred made four errors in his graph of an economy experiencing an inflationary gap, as shown in Figure 8. Can you find all four?
Figure 8: Fred's AD-AS model with three mistakes

Want to join the conversation?

  • old spice man blue style avatar for user Liam Mullany
    Is there such a ting as a Long Run Aggregate Demand Curve?
    (3 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user gm
    The article says "If current real GDP is less than full employment output, an economy is in a recession. If current real GDP is higher than full employment output, an economy is experiencing a boom."
    But based on the previous videos, my understanding is that even if the current rGDP is higher than the full employment output, the economy can be in either recession or an expansion. So wouldn't it not be able to determine if an economy is during expansion or recession only by looking at the relationship between full employment output and current rGDP?
    (2 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user Jarod Simpson
    Why will short run disequilibrium not fix itself? In other words, why does it have to be fixed through government intervention?
    (0 votes)
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    • hopper cool style avatar for user gosoccerboy5
      If you are talking about SRAS≠AD, that will always recover almost immediately because there will be a shortage or surplus, and those tend to get back quickly.

      If you are talking about the intersection of AD and SRAS not being on LRAS, that doesn't always require government intervention, but sometimes certain factors slow it down (search up "sticky wages").

      Hopefully I answered your question well enough!
      (3 votes)