AD-AS Equilibrium and Long-Run Self-Adjustment
Imagine that after a hot summer of spending, your town's stores are packed, hiring signs are everywhere, and prices on everything from burgers to rent keep creeping up. Is the economy healthy, or is it running too hot? And what happens if nobody does anything about it? The AD-AS model gives you a way to answer both questions.
Short-Run Equilibrium and Long-Run Equilibrium
On the AD-AS graph, the vertical axis is the price level (PL) and the horizontal axis is real GDP (Y). Three curves matter: aggregate demand (AD, downward sloping), short-run aggregate supply (SRAS, upward sloping), and long-run aggregate supply (LRAS, vertical at full-employment output, $Y_f$).
Why must all three meet? SRAS tells you what firms produce at today's wages and input prices. LRAS tells you what the economy can sustainably produce when everything has adjusted. Only when they agree is there no pressure for wages and prices to change.
Define short-run macroeconomic equilibrium in the AD-AS model. Then say what must be true of AD, SRAS, and LRAS for the economy to be in long-run equilibrium.
Define short-run macroeconomic equilibrium in the AD-AS model. Then say what must be true of AD, SRAS, and LRAS for the economy to be in long-run equilibrium.
Shifts in AD and SRAS in the Short Run
Start in long-run equilibrium. A demand shock moves AD; a supply shock moves SRAS. Each one moves the short-run equilibrium along the other curve.
| Shock | Curve shift | PL | Real GDP | Unemployment |
|---|---|---|---|---|
| Rise in C, I, G, or net exports | AD right | Up | Up | Down |
| Fall in C, I, G, or net exports | AD left | Down | Down | Up |
| Higher input costs (oil, wages) | SRAS left | Up | Down | Up |
| Higher productivity, cheaper inputs | SRAS right | Down | Up | Down |
Remember $AD = C + I + G + (X - M)$. Anything that changes one of those spending components at every price level shifts AD. Examples: consumer confidence, a stock market boom (wealth), interest rates, government spending, foreign income.
Consumer confidence rises sharply and households increase spending. Which curve shifts, and in which direction? Describe the short-run effect on the price level and real…
Consumer confidence rises sharply and households increase spending. Which curve shifts, and in which direction? Describe the short-run effect on the price level and real GDP.
A sudden increase in oil prices shifts SRAS to the left in an economy that begins in long-run equilibrium. (a) Describe the effect on the price level, real GDP, and…
A sudden increase in oil prices shifts SRAS to the left in an economy that begins in long-run equilibrium. (a) Describe the effect on the price level, real GDP, and unemployment in the short run. (b) Explain why this situation is a difficult challenge for policymakers. (c) If the government does nothing, describe how the economy eventually returns to long-run equilibrium.
Recessionary and Inflationary Gaps
A shock can leave the short-run equilibrium away from $Y_f$. The distance is called a gap.
The size of the gap is the difference: $\text{gap} = Y_f - Y$ for a recessionary gap, or $Y - Y_f$ for an inflationary one.
Define a recessionary gap and an inflationary gap. For each, say whether short-run equilibrium real GDP is above or below full-employment output.
Define a recessionary gap and an inflationary gap. For each, say whether short-run equilibrium real GDP is above or below full-employment output.
An economy has full-employment output of $\$10{,}000$ billion, but short-run equilibrium real GDP is $\$9{,}600$ billion. (a) Identify the type of gap and its size. (b)…
An economy has full-employment output of $\$10{,}000$ billion, but short-run equilibrium real GDP is $\$9{,}600$ billion. (a) Identify the type of gap and its size. (b) Explain what happens to nominal wages and input prices over time if the government does nothing. (c) Describe the resulting shift of SRAS and the final long-run equilibrium price level and real GDP relative to the starting point.
Long-Run Self-Adjustment
If the government does nothing, will a gap last forever? In the AD-AS model, no. Nominal wages and input prices are "sticky" in the short run, but they do adjust over time. That adjustment moves SRAS.
Recessionary gap: unemployment is high and many firms have idle capacity. Workers and suppliers eventually accept lower nominal wages and input prices. Production gets cheaper, so SRAS shifts right. The price level falls and real GDP rises until the economy returns to $Y_f$.
Inflationary gap: unemployment is below the natural rate, so workers and suppliers can demand higher wages and input prices. Production gets costlier, so SRAS shifts left. The price level rises further and real GDP falls back to $Y_f$.
| Starting gap | Pressure on wages and input prices | SRAS shift | Long-run result |
|---|---|---|---|
| Recessionary | Down | Right | $Y = Y_f$, price level lower than before |
| Inflationary | Up | Left | $Y = Y_f$, price level higher than before |
Notice that AD does not move in this story. Only SRAS does, because wages and input prices changed. The adjustment can be slow, which is why the speed of wage adjustment matters for policy.
The table below shows an economy's aggregate demand, short-run aggregate supply, and long-run aggregate supply (real GDP in billions of dollars). | Price level | Real…
The table below shows an economy's aggregate demand, short-run aggregate supply, and long-run aggregate supply (real GDP in billions of dollars).
| Price level | Real GDP demanded | Real GDP supplied, short run | Real GDP supplied, long run |
|---|---|---|---|
| 100 | 12,000 | 9,500 | 11,000 |
| 110 | 11,500 | 10,500 | 11,000 |
| 120 | 11,000 | 11,000 | 11,000 |
| 130 | 10,500 | 11,500 | 11,000 |
(a) Find the initial equilibrium price level and real GDP. (b) Aggregate demand then falls by $\$1{,}000$ billion at every price level. Find the new short-run equilibrium and identify the gap. (c) State the direction in which SRAS will shift in the long run.
An economy begins in long-run equilibrium. A stock market boom raises household wealth, increasing consumption. (a) Show and explain the effect on AD and on the…
An economy begins in long-run equilibrium. A stock market boom raises household wealth, increasing consumption. (a) Show and explain the effect on AD and on the short-run price level and real GDP. (b) Identify the gap that arises and explain what happens to unemployment relative to the natural rate. (c) Explain how nominal wages and SRAS adjust over time, and describe the final long-run equilibrium compared with the original one. (d) Explain how the Federal Reserve could use contractionary monetary policy to prevent the economy from overheating, and what the likely effect on AD would be.
Wait or Act? Policy and the Speed of Adjustment
Self-adjustment is automatic but can be slow, with high unemployment in the meantime. Policymakers can try to speed things up with stabilization policy.
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Expansionary policy (higher government spending, lower taxes, or the Federal Reserve lowering interest rates) shifts AD right to close a recessionary gap.
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Contractionary policy (lower spending, higher taxes, or the Fed raising interest rates) shifts AD left to close an inflationary gap.
Compare the options after a recessionary gap:
| Do nothing | Expansionary policy | |
|---|---|---|
| Short run | Output stays below $Y_f$, unemployment stays high | AD shifts right: output rises, unemployment falls |
| Long run | SRAS shifts right: $Y_f$, lower price level | $Y_f$ reached sooner, price level back near original |
| Risks | Slow recovery if wages are very sticky | Overshooting into an inflationary gap, larger deficit, policy lags |
So which is better? It depends on the speed of wage adjustment. If wages and prices are flexible and fall quickly, waiting costs little. If they are very sticky, waiting means a long period of lost output and jobs, and action looks better. Policy also has lags: by the time it takes effect, the economy may have already healed.
An economy starts in long-run equilibrium with a price level of 100 and full-employment output of $\$20{,}000…
An economy starts in long-run equilibrium with a price level of 100 and full-employment output of $\$20{,}000$ billion. A negative supply shock moves the short-run equilibrium to a price level of 108 and real GDP of $\$19{,}000$ billion. Policymaker Ava proposes expansionary fiscal policy to restore output. Policymaker Liam proposes doing nothing and waiting. Compare the two options in terms of the price level, real GDP, and unemployment in the short run and the long run. Which option do you think is better, and what assumptions about the speed of wage adjustment does your answer rely on?
Back to the start: a summer of heavy spending is an AD increase. If it pushes real GDP above $Y_f$, you have an inflationary gap: tight labor markets, rising prices. Left alone, rising wages shift SRAS left and bring output back to $Y_f$ at an even higher price level. The Fed can try to prevent that by shifting AD back to the left.