Short-run equilibrium is where aggregate demand crosses short-run aggregate supply. Comparing that point with LRAS tells you whether the economy is in long-run equilibrium, a recessionary gap, or an inflationary gap, and whether unemployment is above or below the natural rate. Drag the curves to see each case, then practice reading graphs on your own.
Dashed grey lines show long-run equilibrium (real GDP of $1,000 billion at a price level of 100). Drag AD or SRAS left and right on the graph, or use the sliders. The shaded band is the output gap between short-run output and full-employment output (Yf).
The price level and real GDP where the AD curve crosses the SRAS curve. This is where the economy actually is right now, and it can sit to the left of, on, or to the right of LRAS.
All three curves cross at one point. Real GDP equals potential output (Yf), unemployment equals the natural rate, and cyclical unemployment is zero. Unemployment is not zero.
AD and SRAS cross to the left of LRAS. Real GDP is below potential, so it is a negative output gap. Firms need fewer workers, so unemployment is above the natural rate.
AD and SRAS cross to the right of LRAS. Real GDP is above potential, so it is a positive output gap. Firms push workers and machines past normal use, so unemployment is below the natural rate.
Output gap = actual real GDP − potential real GDP. Divide by potential and multiply by 100 to get it as a percent. A negative number is a recessionary gap; a positive number is an inflationary gap.
The type of gap depends only on where short-run output sits relative to Yf. A high price level alone does not mean an inflationary gap. An oil price shock raises the price level and still creates a recessionary gap.
The first three rows are the three states. The rest start from long-run equilibrium and show the short-run result of one shift. Memorize both halves.
| Situation | Where AD meets SRAS | Output gap | Unemployment | Price level vs. start |
|---|---|---|---|---|
| Long-run equilibrium | On LRAS (at Yf) | None (Y = Yf) | Equal to the natural rate | Any level |
| Recessionary gap | Left of LRAS | Negative (Y < Yf) | Above the natural rate | Depends on the cause |
| Inflationary gap | Right of LRAS | Positive (Y > Yf) | Below the natural rate | Depends on the cause |
| AD decreases (falling confidence, lower spending) | Left of LRAS | Recessionary | Above natural rate | ↓ |
| AD increases (more spending, tax cut) | Right of LRAS | Inflationary | Below natural rate | ↑ |
| SRAS decreases (oil price or wage increase) | Left of LRAS | Recessionary (stagflation) | Above natural rate | ↑ |
| SRAS increases (lower input prices) | Right of LRAS | Inflationary (positive gap) | Below natural rate | ↓ |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 3.5. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 3 terminology guide.