Macroeconomics guide, Unit 3, step 8 of 23Previous step Next step

Step 8: Macroeconomic Equilibrium

By the EconTutorials team. 10-minute read with 6 practice questions.

SyllabusAP Macro 3.5–3.7 · Cambridge 4.3 · IB 3.2

In 30 seconds

Short-run equilibrium is where aggregate demand (AD) meets short-run aggregate supply (SRAS). Long-run equilibrium needs AD, SRAS and long-run aggregate supply (LRAS) to cross at one point.
If output is below potential there is a recessionary gap; if it is above potential there is an inflationary gap. Output gap $ = \frac{Y – Y_p}{Y_p} \times 100 $.
Gaps close themselves: nominal wages adjust, SRAS shifts, and the economy slides along AD back to potential. AD itself does not move.
Exam point: a demand shift changes output only in the short run. In the long run, because LRAS is vertical, it changes only the price level.

Video lesson coming soonA short animated lesson for this step will appear here.

Putting the two halves together

Think of a café. It is “in balance” when the number of coffees made equals the number people want to buy. But that does not tell you whether the café is running at full capacity. It might be busy and balanced, or half empty and still balanced.

The whole economy works the same way. Put aggregate demand (total spending at each price level) and aggregate supply on one diagram, with the price level on the vertical axis and real GDP (output) on the horizontal.

The economy is in short-run equilibrium where AD crosses SRAS. At that price level, what firms want to produce equals what buyers want to purchase. Notice that this says nothing about whether output equals potential output ($Y_p$), the level the economy can produce when unemployment is at its natural rate.

The economy is in long-run equilibrium only when all three curves, AD, SRAS and LRAS, pass through a single point. Then the goods market clears and output equals potential, unemployment is at its natural rate, and there is no pressure on wages to change.

Key termLong-run equilibrium: the point where AD, SRAS and LRAS all intersect, so output equals potential and unemployment equals its natural rate.

Exam tipA favourite trick is to draw AD crossing SRAS at a point that is not on LRAS and ask “is the economy in equilibrium?” The full answer is: yes, in short-run equilibrium; no, not in long-run equilibrium. Both are true at once, so say both.

Recessionary and inflationary gaps

When short-run output is not at potential, there is a gap.

	Recessionary gap	Inflationary gap
Output	Below potential	Above potential
Unemployment	Above the natural rate	Below the natural rate
Other name	Negative output gap	Positive output gap
Pressure on wages	Downward	Upward

You measure the size of the gap as a percentage of potential output:

\[ \text{Output gap (\%)} = \frac{Y – Y_p}{Y_p} \times 100 \]

A negative answer is a recessionary gap; a positive answer is an inflationary gap; zero means the economy is already at potential.

Worked example

Aggregate demand is $Y = 5{,}000 – 10P$ and short-run aggregate supply is $Y = 2{,}000 + 20P$, where $Y$ is real GDP in $bn and $P$ is the price level. Potential output is $4,200bn. Find the short-run equilibrium and the output gap.

Step 1Set AD equal to SRAS: $ 5{,}000 – 10P = 2{,}000 + 20P \Rightarrow 3{,}000 = 30P \Rightarrow P = 100 $

Step 2Find output: $ Y = 2{,}000 + 20(100) = 4{,}000 $. Check with AD: $ 5{,}000 – 10(100) = 4{,}000 $ ✓

Step 3Output gap: $ \frac{4{,}000 – 4{,}200}{4{,}200} \times 100 = -4.76\% $ (to 2 d.p.)

The economy is in short-run equilibrium at a price level of 100 and output of $4,000bn, but it is producing about 4.8% less than it could. This is a recessionary gap, and unemployment is above its natural rate.

How the economy corrects itself

A gap sets off the forces that close it. This self-correction mechanism works through the labour market.

Closing a recessionary gap. Imagine business confidence collapses, AD falls, and the economy ends up below potential. Follow the four steps in order:

Output is below potential, so unemployment is above the natural rate.
With many workers chasing few jobs, workers have less bargaining power. When contracts are renewed, nominal wages (wages in money terms) rise more slowly or fall.
Lower wages cut firms’ costs at every price level, so SRAS shifts right.
The economy slides down the unchanged AD curve. Output rises and the price level falls, until output is back at potential. Then the wage pressure stops.

The economy ends in a new long-run equilibrium: the same output as before, at a lower price level. In the worked example, it would end on the same AD curve at $Y = 4{,}200$: $4{,}200 = 5{,}000 – 10P$ gives $P = 80$, down from 100.

Closing an inflationary gap works the same way in reverse. Output above potential means unemployment is below the natural rate. Firms compete for scarce workers, wages are bid up, costs rise and SRAS shifts left. The economy moves up the AD curve until output is back at potential, at a higher price level.

Key termSelf-correction: the process by which changes in nominal wages shift SRAS and return output to potential without any government action.

Common mistakeSaying that AD shifts right as the economy recovers from a recession. It does not. Nothing has made anyone want to spend more at a given price level. What has changed is the cost of production, and costs belong to supply. SRAS moves; the economy travels along AD to meet it.

Same logic, different speed

The two cases are symmetric in logic but not in speed. Closing an inflationary gap needs wages to rise, which workers happily accept. Closing a recessionary gap needs wages to fall, which workers strongly resist: downward nominal wage rigidity. So recovery from a recession is much slower, which is the strongest technical argument for active stabilisation policy.

Demand shocks: short run versus long run

Suppose the government launches a fiscal stimulus that shifts AD permanently to the right. Trace it through two stages.

Short run: the economy moves up along SRAS. Output rises above potential, unemployment falls and the price level rises. The policy seems to have worked.
Long run: output above potential means wages are bid up. SRAS shifts left and the economy climbs up the new AD curve until output returns to potential. Output is back where it started, and the price level is higher still.

The real gain disappears; only higher prices remain. This idea is called the long-run neutrality of demand policy: because LRAS is vertical, a shift in AD changes only the price level in the long run. Demand policy decides inflation, not growth.

Demand policy is not useless: used to close a recessionary gap, it speeds up a slow, painful correction. Used to push output beyond potential, it buys a short boom with lasting inflation.

Exam tip“Analyse the short-run and long-run effects” means a two-stage answer. Stage one: move along SRAS. Stage two: SRAS shifts because wages adjust. State what happens to output and the price level at each stage, and say that long-run output returns to $Y_p$. Answers that stop at stage one lose half the marks.

Supply shocks: temporary or permanent?

Supply shocks behave differently, and that difference is why the AD/AS model is so useful.

A temporary adverse supply shock, such as an oil price spike, a drought or a shipping disruption, shifts SRAS left. Output falls and the price level rises at the same time. This mix is called stagflation. But LRAS has not moved, so self-correction still works: SRAS eventually shifts back and the economy returns to potential at the original price level. Painful, but reversible.

A permanent adverse supply shock is different in kind. If potential output itself falls, for example through destroyed capital, an exhausted resource, or hysteresis (long unemployment that wears away workers’ skills), then LRAS shifts left. There is nothing to return to. Output stays lower and prices stay higher for good.

Telling the two apart in real time is very hard. In 2021 the US Federal Reserve judged pandemic supply-chain problems to be temporary. It was largely right about the mechanism but wrong about the size and length of the inflation, because large fiscal support had also pushed AD right.

How long is the long run?

Classical and Keynesian economists agree on everything above: LRAS is vertical, self-correction exists, and demand policy is neutral in the long run. They disagree on one question: how long does the adjustment take?

Classical view: wages and prices are flexible, so correction is quick. Government action arrives late and can be misused. Set credible rules and leave the economy alone.
Keynesian view: wages are rigid downward, so an economy can sit below potential for years, and long unemployment damages skills and shifts LRAS left. Waiting is not neutral.

The chapter’s evidence includes the Great Depression. Between 1929 and 1933 US real GDP fell about 26% and unemployment rose to roughly 25%; wages fell only slowly, and falling prices raised the real burden of debt. When policy tightened in 1937 with unemployment still above 14%, output fell 10% within a year. As Keynes put it: “In the long run we are all dead.”

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. An AD/AS diagram shows AD crossing SRAS to the left of LRAS. Is the economy in equilibrium? Show worked answer

It is in short-run equilibrium, because AD meets SRAS.
It is not in long-run equilibrium, because the point is not on LRAS: output is below potential.
This is a recessionary gap, with unemployment above the natural rate.

EasyQ2. Real GDP is $950bn and potential output is $1,000bn. Calculate the output gap and name it. Show worked answer

$ \frac{950 – 1{,}000}{1{,}000} \times 100 = \frac{-50}{1{,}000} \times 100 = -5\% $
The gap is negative, so it is a recessionary gap of 5%.

MediumQ3. AD is $Y = 3{,}000 – 10P$ and SRAS is $Y = 1{,}000 + 10P$. Potential output is 1,800. Find the short-run equilibrium and the output gap. Show worked answer

Set AD = SRAS: $3{,}000 – 10P = 1{,}000 + 10P \Rightarrow 2{,}000 = 20P \Rightarrow P = 100$.
$Y = 1{,}000 + 10(100) = 2{,}000$. Check: $3{,}000 – 1{,}000 = 2{,}000$ ✓
Output gap $ = \frac{2{,}000 – 1{,}800}{1{,}800} \times 100 = 11.1\% $ (to 1 d.p.).
It is positive, so this is an inflationary gap.

MediumQ4. Using Q3, the economy self-corrects. Find the long-run price level and the new SRAS equation of the form $Y = c + 10P$. Show worked answer

Output above potential means wages are bid up and SRAS shifts left until $Y = 1{,}800$ on the same AD curve.
From AD: $1{,}800 = 3{,}000 – 10P \Rightarrow 10P = 1{,}200 \Rightarrow P = 120$.
New SRAS through (1,800, 120): $1{,}800 = c + 10(120) \Rightarrow c = 600$.
New SRAS: $Y = 600 + 10P$. The price level has risen from 100 to 120 and output is back at potential.

MediumQ5. Compare the long-run effects of (a) a temporary doubling of oil prices and (b) a permanent loss of capital in a war. Show worked answer

(a) SRAS shifts left; LRAS does not move. Short run: output falls and the price level rises (stagflation). Long run: SRAS shifts back, so output returns to potential and the price level returns to its original level.
(b) Potential output falls, so LRAS shifts left (SRAS also shifts left). Output settles permanently lower and the price level permanently higher. There is no old equilibrium to return to.

ExamQ6. Explain how an economy self-corrects from a recessionary gap, and why this is slower than correcting an inflationary gap. [6 marks] Show worked answer

Diagram (1): price level and real GDP axes, vertical LRAS at $Y_p$, AD, SRAS1 crossing AD left of LRAS, SRAS2 to the right crossing AD on LRAS at a lower price level.
Mechanism (3): output below potential, so unemployment is above the natural rate (1). Workers’ bargaining power weakens, so nominal wages fall or grow more slowly (1). Lower costs shift SRAS right, and the economy moves down the unchanged AD curve until output returns to $Y_p$ at a lower price level (1).
Why slower (2): an inflationary gap needs wages to rise, which workers readily accept (1). A recessionary gap needs nominal wages to fall, which workers resist (downward wage rigidity), so SRAS shifts right only slowly and the gap can last for years (1).

Check yourself

1. An economy is in long-run equilibrium when:

Long-run equilibrium also needs output at potential, which the LRAS intersection guarantees.

2. An economy at a recessionary gap self-corrects through:

High unemployment pushes wages down, cutting costs and shifting SRAS right; AD does not move.

3. In the long run, a permanent increase in AD will:

LRAS is vertical, so AD shifts change only the price level in the long run.

Your score: 0 out of 3

The short version

Short-run equilibrium: AD meets SRAS. Long-run equilibrium: AD, SRAS and LRAS meet at one point, with output at potential.
Output below potential is a recessionary gap; above potential is an inflationary gap. Measure it as $ \frac{Y – Y_p}{Y_p} \times 100 $.
Self-correction works through wages shifting SRAS; the economy moves along an unchanged AD curve. It is slow from below because wages resist falling.
Demand shocks change output only in the short run; in the long run they change only the price level. Temporary supply shocks reverse; permanent ones shift LRAS.
Classical and Keynesian economists disagree only on how fast self-correction is, and whether waiting causes lasting damage.

This guide covers the core of Chapter 25 of Economics Made Simple. For the full chapter, with diagrams, the Great Depression case study and 15 exam-style questions with a complete answer key, see the book.