U3.5 Equilibrium in the AD-AS Model
Master short-run and long-run equilibrium in the AD-AS model, tell recessionary gaps from inflationary gaps, and link them to cyclical unemployment.
What you'll do in this lesson
A voice-first session with the Crimsora tutor on U3.5 Equilibrium in the AD-AS Model, then targeted practice and FRQs — with the tutor adapting to where you get stuck.
What this lesson covers
By now you can draw aggregate demand, short-run aggregate supply, and long-run aggregate supply as separate curves. This lesson puts them on one graph and asks the key question: where does the economy actually settle? Equilibrium is where curves cross, but the AD-AS model has two kinds of equilibrium — a short-run point and a long-run point — and they do not always match.
When they do not match, the economy has an output gap. Learning to spot whether that gap is recessionary or inflationary, and what it implies for unemployment and the price level, is one of the most heavily tested skills in Unit 3. Get comfortable reading these three-curve graphs quickly and precisely.
When they do not match, the economy has an output gap. Learning to spot whether that gap is recessionary or inflationary, and what it implies for unemployment and the price level, is one of the most heavily tested skills in Unit 3. Get comfortable reading these three-curve graphs quickly and precisely.
Short-Run vs. Long-Run Equilibrium
Short-run equilibrium occurs where the aggregate demand curve () intersects the short-run aggregate supply curve (). This single crossing point sets the current price level and the current level of real GDP.
Long-run equilibrium is a special situation: it occurs only when all three curves — , , and long-run aggregate supply () — cross at the same point. At that point real GDP equals potential output (also called full-employment output, ), and there is no pressure for the price level to change.
The curve is vertical at potential output because in the long run the economy produces at its full-employment capacity regardless of the price level. The short-run equilibrium can sit to the left of, right of, or exactly on the line.
A common misconception is that the economy is "in long-run equilibrium" whenever crosses . Not true — long-run equilibrium requires that this crossing land precisely on the vertical line.
Long-run equilibrium is a special situation: it occurs only when all three curves — , , and long-run aggregate supply () — cross at the same point. At that point real GDP equals potential output (also called full-employment output, ), and there is no pressure for the price level to change.
The curve is vertical at potential output because in the long run the economy produces at its full-employment capacity regardless of the price level. The short-run equilibrium can sit to the left of, right of, or exactly on the line.
| Feature | Short-run equilibrium | Long-run equilibrium |
|---|---|---|
| Curves that intersect | and | , , and |
| Output | May differ from | Equals |
| Unemployment | May differ from natural rate | Equals natural rate |
| Sustainable? | Not necessarily | Yes, until a curve shifts |
Recessionary Gaps and Cyclical Unemployment
A recessionary gap exists when short-run equilibrium real GDP is less than potential output. On the graph, the - intersection lies to the left of the vertical line.
The size of the gap is the horizontal distance between current output and potential output, measured as . If potential output is 18 trillion dollars and the economy is currently producing 16.5 trillion dollars, the recessionary gap equals 1.5 trillion dollars.
When output is below potential, firms need fewer workers than they would at full employment, so cyclical unemployment is positive and the actual unemployment rate rises above the natural rate. Cyclical unemployment is the component of joblessness caused by a downturn in the business cycle — exactly the situation a recessionary gap describes.
Students often confuse the direction of the gap. Remember: "recessionary" means the economy is producing too little, so the equilibrium sits to the LEFT of , and unemployment is HIGH. The price level is lower than it would be at full employment.
On the exam, you may be asked to shade or label the gap on a correctly drawn graph. Always measure the gap along the horizontal (real GDP) axis, from the current output level to the line — never along the vertical axis.
The size of the gap is the horizontal distance between current output and potential output, measured as . If potential output is 18 trillion dollars and the economy is currently producing 16.5 trillion dollars, the recessionary gap equals 1.5 trillion dollars.
When output is below potential, firms need fewer workers than they would at full employment, so cyclical unemployment is positive and the actual unemployment rate rises above the natural rate. Cyclical unemployment is the component of joblessness caused by a downturn in the business cycle — exactly the situation a recessionary gap describes.
Students often confuse the direction of the gap. Remember: "recessionary" means the economy is producing too little, so the equilibrium sits to the LEFT of , and unemployment is HIGH. The price level is lower than it would be at full employment.
On the exam, you may be asked to shade or label the gap on a correctly drawn graph. Always measure the gap along the horizontal (real GDP) axis, from the current output level to the line — never along the vertical axis.
Inflationary Gaps and Overheating
An inflationary gap exists when short-run equilibrium real GDP exceeds potential output. On the graph, the - intersection lies to the right of the vertical line.
This seems strange — how can an economy produce more than its "full-employment" output? In the short run, firms can push workers into overtime, run machines longer, and hire the temporarily unemployed. Output overshoots potential, but only temporarily. During an inflationary gap, cyclical unemployment is negative, meaning the actual unemployment rate falls below the natural rate.
Because resources are stretched thin, there is strong upward pressure on wages and prices, so the price level is higher than it would be at full-employment equilibrium. The gap size again equals the horizontal distance to , calculated as .
A frequent error is calling any period of rising prices an inflationary gap. The defining feature is output above potential, not just inflation itself.
This seems strange — how can an economy produce more than its "full-employment" output? In the short run, firms can push workers into overtime, run machines longer, and hire the temporarily unemployed. Output overshoots potential, but only temporarily. During an inflationary gap, cyclical unemployment is negative, meaning the actual unemployment rate falls below the natural rate.
Because resources are stretched thin, there is strong upward pressure on wages and prices, so the price level is higher than it would be at full-employment equilibrium. The gap size again equals the horizontal distance to , calculated as .
| Gap type | Output vs. | Position vs. | Unemployment vs. natural rate |
|---|---|---|---|
| Recessionary | Below | Left | Above (positive cyclical) |
| Inflationary | Above | Right | Below (negative cyclical) |
| None (long-run) | Equal | On the line | Equal (zero cyclical) |
Reading and Labeling AD-AS Graphs on the Exam
AP questions almost always require a correctly drawn and fully labeled graph. Put the price level () on the vertical axis and real GDP () on the horizontal axis. Draw downward sloping, upward sloping, and as a vertical line at .
To identify the type of equilibrium, follow three steps. First, find where crosses ; drop a line down to read current output. Second, compare that output to the position. Third, name the gap and state the unemployment implication.
Graders reward precision. If the prompt says the economy is in a recessionary gap, your - intersection must clearly sit to the left of , and the current output level should be labeled distinctly from . Sloppy graphs where the intersection sits on the line will lose points.
Expect follow-up questions connecting the gap to policy (previewed in later lessons) or to self-correction. For this topic, focus on the diagnosis: identify the equilibrium, name the gap, and state what happens to cyclical unemployment and the price level relative to full employment. Practice sketching all three scenarios from a blank axis until it is automatic.
To identify the type of equilibrium, follow three steps. First, find where crosses ; drop a line down to read current output. Second, compare that output to the position. Third, name the gap and state the unemployment implication.
Graders reward precision. If the prompt says the economy is in a recessionary gap, your - intersection must clearly sit to the left of , and the current output level should be labeled distinctly from . Sloppy graphs where the intersection sits on the line will lose points.
Expect follow-up questions connecting the gap to policy (previewed in later lessons) or to self-correction. For this topic, focus on the diagnosis: identify the equilibrium, name the gap, and state what happens to cyclical unemployment and the price level relative to full employment. Practice sketching all three scenarios from a blank axis until it is automatic.
Key terms
- Short-run equilibrium.
- The point where aggregate demand intersects short-run aggregate supply, determining the current price level and real GDP.
- Long-run equilibrium.
- The situation where , , and all intersect at one point, so real GDP equals potential output.
- Potential output ().
- The full-employment level of real GDP, shown by the vertical curve, where only natural unemployment exists.
- Recessionary gap.
- The amount by which short-run real GDP falls below potential output; the - intersection lies left of .
- Inflationary gap.
- The amount by which short-run real GDP exceeds potential output; the - intersection lies right of .
- Cyclical unemployment.
- Unemployment caused by fluctuations in the business cycle; positive during recessionary gaps and negative during inflationary gaps.
- Natural rate of unemployment.
- The unemployment rate that prevails when the economy produces at potential output, including frictional and structural unemployment but no cyclical unemployment.
Worked example
An economy has potential output of 18 trillion dollars. Currently, aggregate demand intersects short-run aggregate supply at a real GDP of 16.5 trillion dollars. Identify the type of gap, calculate its size, and state what is happening to cyclical unemployment.
Step 1: Compare current output to potential. Current short-run output is 16.5 trillion dollars, while potential output (the line) is 18 trillion dollars. Because current output is below potential, the - intersection lies to the left of .
Step 2: Name the gap. Output below potential means this is a recessionary gap.
Step 3: Calculate the size. The gap is the horizontal distance between current output and potential: trillion dollars. So the recessionary gap equals 1.5 trillion dollars.
Step 4: Connect to unemployment. In a recessionary gap the economy produces less than full-employment output, so firms employ fewer workers than at full employment. Cyclical unemployment is positive, and the actual unemployment rate is above the natural rate.
Step 5: Note the price level. Because equilibrium output is below potential, the price level is lower than it would be at full-employment equilibrium. A complete FRQ answer would also draw the graph with the - crossing clearly left of the vertical line.
Step 2: Name the gap. Output below potential means this is a recessionary gap.
Step 3: Calculate the size. The gap is the horizontal distance between current output and potential: trillion dollars. So the recessionary gap equals 1.5 trillion dollars.
Step 4: Connect to unemployment. In a recessionary gap the economy produces less than full-employment output, so firms employ fewer workers than at full employment. Cyclical unemployment is positive, and the actual unemployment rate is above the natural rate.
Step 5: Note the price level. Because equilibrium output is below potential, the price level is lower than it would be at full-employment equilibrium. A complete FRQ answer would also draw the graph with the - crossing clearly left of the vertical line.
Practice questions
In the AD-AS model, an economy is in long-run equilibrium when which of the following is true?
- Aggregate demand intersects short-run aggregate supply to the right of the long-run aggregate supply curve
- Aggregate demand, short-run aggregate supply, and long-run aggregate supply all intersect at the same point
- Short-run aggregate supply intersects long-run aggregate supply below current output
- Aggregate demand intersects short-run aggregate supply to the left of the long-run aggregate supply curve
Answer: Aggregate demand, short-run aggregate supply, and long-run aggregate supply all intersect at the same point
Long-run equilibrium is the special case in which output equals potential, which requires all three curves to cross at one point on the vertical line. An intersection to the right indicates an inflationary gap, and one to the left indicates a recessionary gap — neither is long-run equilibrium.
An economy's short-run equilibrium output is 22 trillion dollars while its potential output is 20 trillion dollars. Identify the type of output gap, its size, and describe what is happening to cyclical unemployment and the price level relative to full employment.
Answer: There is an inflationary gap of 2 trillion dollars; cyclical unemployment is negative (unemployment below the natural rate) and the price level is higher than it would be at full-employment equilibrium.
Because current output (22 trillion dollars) exceeds potential (20 trillion dollars), the - intersection is right of , defining an inflationary gap. Its size is the horizontal distance, trillion dollars. Producing above potential means firms overuse resources, pushing the actual unemployment rate below the natural rate (negative cyclical unemployment) and driving the price level above the full-employment level.
During a recessionary gap, how does the actual unemployment rate compare to the natural rate of unemployment, and why?
Answer: The actual unemployment rate is above the natural rate because cyclical unemployment is positive.
A recessionary gap means real GDP is below potential, so firms need fewer workers than at full employment. This creates positive cyclical unemployment, which adds to the frictional and structural unemployment already present at the natural rate, pushing the actual rate above the natural rate.
FAQ
- How do I quickly tell a recessionary gap from an inflationary gap on a graph?
- Find where crosses and compare it to the vertical line. If the crossing is to the left of , output is below potential, so it is a recessionary gap. If it is to the right, output is above potential, so it is an inflationary gap.
- Can real GDP really be higher than potential output?
- Yes, temporarily. In the short run firms can use overtime, extra shifts, and hire the temporarily unemployed, pushing output above potential. This creates an inflationary gap with negative cyclical unemployment, but it is not sustainable in the long run.
- How do I measure the size of an output gap?
- Measure the horizontal distance between current short-run output and potential output along the real GDP axis. For a recessionary gap it is potential minus current output; for an inflationary gap it is current output minus potential. Never measure it vertically.
- Does an inflationary gap simply mean prices are rising?
- No. The defining feature is that real GDP exceeds potential output, not merely that prices are increasing. Rising prices can occur for other reasons, but an inflationary gap specifically means the - equilibrium sits to the right of .
Learn this with a teacher, not a page
The Crimsora tutor teaches U3.5 Equilibrium in the AD-AS Model live — explaining on a whiteboard, asking you questions, and adapting to where you get stuck.