AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/3/3-5)
Unit 3 · Topic 3.5
3.5 Equilibrium in the Aggregate Demand–Aggregate Supply (AD–AS) Model
The AD–AS model puts aggregate demand, short-run aggregate supply and long-run aggregate supply on one graph. Short-run equilibrium is where AD and SRAS cross. Comparing that output to full-employment output tells you whether the economy has a recessionary gap, an inflationary gap or is in long-run equilibrium, and what that means for unemployment.
Key terms
- short-run equilibrium
- long-run equilibrium
- full-employment output (YF)
- recessionary (negative) output gap
- inflationary (positive) output gap
Drawing the full graph
Label the vertical axis "Price Level" (PL) and the horizontal axis "Real GDP" (or "Real Output"). Draw a downward-sloping AD curve, an upward-sloping SRAS curve, and a vertical LRAS line. Mark full-employment output YF where LRAS meets the horizontal axis.
Short-run equilibrium is where AD crosses SRAS. Draw dashed lines from that point to each axis and label them PL1 and Y1. At that point, the total quantity of output demanded equals the total quantity supplied.
Why does the economy settle there? If the price level were above PL1, firms would be producing more than buyers want, so unsold goods would pile up in inventories. Firms would cut production and prices, moving the economy back toward PL1 and Y1. Below PL1, buyers want more than firms produce, inventories run down, and firms raise output and prices.
Three possible situations
Long-run equilibrium means all three curves cross at one point: the economy is producing YF and nothing is pushing wages or prices to change.
In a recessionary (negative) gap, the economy is producing less than it can sustain. Cyclical unemployment is positive, and there's downward pressure on wages.
In an inflationary (positive) gap, the economy is producing more than it can sustain. Firms run overtime, unemployment falls below the natural rate, and there's upward pressure on wages and prices.
| Situation | Where AD and SRAS cross | Output gap | Unemployment |
|---|---|---|---|
| Long-run equilibrium | On LRAS, so Y1 = YF | None | At the natural rate |
| Recessionary gap | Left of LRAS, so Y1 < YF | Negative | Above the natural rate |
| Inflationary gap | Right of LRAS, so Y1 > YF | Positive | Below the natural rate |
Connecting to other measures
This graph ties together Unit 2. The output gap is the same one on the business cycle graph (2.7): a recessionary gap matches a point below the trend line, and an inflationary gap a point above it. Unemployment above or below the natural rate links to 2.3.
It also sets up everything that follows. Once you can see which situation the economy is in, you can predict how it fixes itself in the long run (3.7) or which policy would close the gap (3.8 and 4.6).
Graphing tips that earn points
- Label the axes with "Price Level" and "Real GDP," never "Price" and "Quantity."
- Label every curve (AD, SRAS, LRAS) and mark YF on the horizontal axis.
- Show the equilibrium price level and output on the axes (PL1, Y1), usually with dashed lines.
- Place the crossing point on the correct side of LRAS for the situation the question describes.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Equilibrium from a schedule
An economy's aggregate demand and short-run aggregate supply (real GDP in billions) are: at price level 100, AD 900 and SRAS 700; at 110, AD 850 and SRAS 750; at 120, AD 800 and SRAS 800; at 130, AD 750 and SRAS 850; at 140, AD 700 and SRAS 900. Full-employment output is $850 billion. (a) Find short-run equilibrium. (b) What kind of gap is there, and how big? (c) Compare unemployment with the natural rate.
Show the solutionHide the solution
- Step 1: (a) Short-run equilibrium is where the quantity demanded equals the quantity supplied: at price level 120, both are $800 billion.
- Step 2: (b) Y1 = $800 billion is less than YF = $850 billion, so there's a recessionary (negative) output gap of 850 − 800 = $50 billion.
- Step 3: (c) Output below full employment means unemployment is above the natural rate.
Answer: (a) PL = 120, real GDP = $800 billion. (b) A recessionary gap of $50 billion. (c) Unemployment is above the natural rate.
- Example 2
Describing a graph in words
On an AD–AS graph, AD and SRAS cross at real GDP of Y1, which is to the right of the vertical LRAS at YF. Describe the economy's situation and what's happening in the labor market.
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- Step 1: The crossing is right of LRAS, so Y1 > YF. The economy is producing more than its full-employment output: a positive (inflationary) output gap.
- Step 2: To produce that much, firms hire extra workers and run overtime, so unemployment is below the natural rate.
- Step 3: A tight labor market puts upward pressure on wages, and the price level tends to rise.
Answer: The economy is in short-run equilibrium with an inflationary gap: output above YF, unemployment below the natural rate, and upward pressure on wages and prices.
Common mistakes
- Calling the AD–SRAS crossing "long-run equilibrium" when it isn't on LRAS. Long-run equilibrium needs all three curves to meet.
- Mixing up the gap names. Output below YF is a recessionary (negative) gap; above YF is an inflationary (positive) gap.
- Saying unemployment is zero in an inflationary gap. It's below the natural rate, not zero.
- Forgetting to draw LRAS. Without it, the reader can't see whether there's a gap.
On the exam
- The long free-response question very often asks for a correctly labeled AD–AS graph, with AD, SRAS and LRAS, showing a given situation. Practice drawing all three cases quickly.
- Expect follow-up parts asking whether unemployment is above, below or equal to the natural rate, so always compare Y1 with YF.
Connected topics
Videos
Check yourself
4 questions on 3.5 Equilibrium in the Aggregate Demand–Aggregate Supply (AD–AS) Model. Pick an answer to see if you got it, and why.
On a graph with the price level on the vertical axis and real GDP (in billions of dollars) on the horizontal axis, the downward-sloping AD curve and the upward-sloping SRAS curve intersect at a price level of 110 and real GDP of $900 billion.
The vertical LRAS curve is at real GDP of $1,000 billion.
Described AD–AS graph
Which of the following describes this economy?
At the short-run equilibrium shown, the unemployment rate is
An economy is in long-run equilibrium when
On an AD–AS graph, AD1 intersects SRAS1 at price level PL1 and real output Y1, and Y1 is to the right of the vertical LRAS curve at full-employment output YF. Which of the following is true?
0 of 4 answered