Introduction
Hello! Welcome back. In our last few lessons, we've built the essential components of our main macroeconomic model. We've established:
- The downward-sloping Aggregate Demand (AD) curve, representing total spending.
- The upward-sloping Short-Run Aggregate Supply (SRAS) curve, based on sticky input prices.
- The vertical Long-Run Aggregate Supply (LRAS) curve, anchored at the economy's potential GDP.
Today, we bring all three curves together on one graph. Our goal is to use this complete AD-AS model to identify and understand the different states of the economy. By the end of this lesson, you will be able to distinguish between short-run equilibrium and long-run equilibrium, and identify when the economy is experiencing a recessionary gap or an inflationary gap.
Understanding these equilibrium states is fundamental for a financial analyst. It allows you to interpret macroeconomic data to assess whether an economy is overheating, in a downturn, or in a sustainable state, which has direct implications for corporate profits, inflation, and interest rates.
1. The Three States of Macroeconomic Equilibrium
An economy can be in one of three states at any point in time:
- Long-run equilibrium (at full employment)
- A short-run inflationary gap (producing above full employment)
- A short-run recessionary gap (producing below full employment)
Let's begin by watching a video that provides a clear and concise overview of how these three states are represented on the AD-AS graph.
Macro 3.5 & 3.6 AS/AD Equilibrium and Changes
This video from ReviewEcon will quickly get us up to speed. It reviews the AD-AS graph and then clearly shows how the intersection of the curves determines the economy's current state.
Please watch the video from the beginning until 04:30. As you watch, focus on: The definition of short-run equilibrium (where AD and SRAS intersect). How the position of the LRAS curve relative to the short-run equilibrium determines whether there is an inflationary gap, a recessionary gap, or long-run equilibrium.
This video gave us the essential visual framework. Now, let's solidify these concepts with a formal reading that aligns with the CFA curriculum. This will ensure we are comfortable with the precise definitions.
[PDF] PRE-READING Economics - Learning Module 3
The following PDF from Edge Designations, a CFA prep provider, formally defines and illustrates the different types of macroeconomic equilibrium. This will reinforce what you just saw in the video.
Please read the text from page 29 starting at 'Distinguish between the following types...' down to the section on 'Stagflation' on page 31. Focus on the definitions and graphical representations of: Long-run full employment Recessionary Gap Inflationary Gap
Let's summarize and visualize these three crucial concepts.
A. Long-Run Equilibrium
This is the economy's "neutral" or "ideal" state. It occurs where all three curves—AD, SRAS, and LRAS—intersect at a single point.
At long-run equilibrium, actual GDP (Y_e) equals potential GDP (Y_p). The unemployment rate is equal to the natural rate of unemployment (meaning cyclical unemployment is zero), and the price level is stable.
B. Recessionary Gap
This occurs when the economy is underperforming. The short-run equilibrium (where AD intersects SRAS) is at an output level below the economy's potential.
In a recessionary gap, the short-run equilibrium output (Y_e) is less than potential output (Y_p). This corresponds to high unemployment (above the natural rate) and indicates a contracting economy.
C. Inflationary Gap
This occurs when the economy is "overheating." The short-run equilibrium is at an output level above the economy's sustainable potential.
In an inflationary gap, short-run equilibrium output (Y_e) is greater than potential output (Y_p). The economy is producing beyond its long-run capacity, leading to very low unemployment and upward pressure on prices (inflation).
You might wonder how an economy can produce more than its "potential." This happens by using resources unsustainably—for example, by having workers do excessive overtime or running machinery 24/7 without proper maintenance. This can happen in the short run, but it's not sustainable in the long run.
2. A Practical Example: Finding Equilibrium from Data
As you know from your goal of practical application, CFA exams often require you to interpret data tables. Let's practice identifying equilibrium from a schedule of aggregate demand and supply.
Consider the data for the imaginary country of Xurbia.
| Price Level | Aggregate Demand | Aggregate Supply |
|---|---|---|
| 110 | $700 | $600 |
| 120 | $690 | $640 |
| 130 | $680 | $680 |
| 140 | $670 | $720 |
| 150 | $660 | $740 |
Your task:
- Find the short-run equilibrium: At what price level and real GDP does short-run equilibrium occur?
- Analyze the state of the economy: If you are told that Xurbia's potential GDP (LRAS) is at $750, is the economy in a recessionary gap, an inflationary gap, or long-run equilibrium?
Solution:
- Short-run equilibrium occurs where the quantity of aggregate demand equals the quantity of short-run aggregate supply. Looking at the table, this happens at a price level of 130 and a real GDP of $680.
- State of the economy: The equilibrium GDP ($680) is less than potential GDP ($750). Therefore, Xurbia is experiencing a recessionary gap. We would expect to see an unemployment rate higher than the natural rate.
This type of analysis, moving between tables, graphs, and economic interpretation, is a key skill. The resource below provides a step-by-step guide to this process.
24.2 Building a Model of Aggregate Demand and Aggregate Supply
The textbook 'Principles of Economics' provides a 'Work It Out' feature that walks through the exact exercise we just completed, reinforcing the steps to find and interpret macroeconomic equilibrium from a data table.
Please read the feature titled 'Interpreting the AD/AS Model', including steps 1 through 8. This will confirm the logic we used in our example.
3. The Economy's Self-Correcting Mechanism
Recessionary and inflationary gaps are considered short-run phenomena. Economic theory suggests that, in the absence of government intervention, flexible wages and prices will guide the economy back to its long-run equilibrium at potential GDP.
From a Recessionary Gap to Long-Run Equilibrium
In a recessionary gap, high unemployment puts downward pressure on nominal wages. As labor contracts are renegotiated, lower wage costs will increase the profitability of production at any given price level. This causes the SRAS curve to shift to the right. The process continues until the economy returns to full employment (), but at a lower price level.
The image below perfectly illustrates this adjustment.
From an Inflationary Gap to Long-Run Equilibrium
Conversely, in an inflationary gap, the unusually low unemployment rate means firms must compete for workers, putting upward pressure on nominal wages. As wages rise, production costs increase, and the SRAS curve shifts to the left. This shift continues until output falls back to the potential level (), closing the gap and resulting in a higher price level.
To see both of these adjustment processes in action, let's watch one more short video.
Aggregate Demand and Supply and LRAS; Macroeconomics
Jacob Clifford provides a very dynamic and intuitive explanation of how the economy self-corrects from both inflationary and recessionary gaps by shifting the SRAS curve.
Please watch the video from 01:31 to 03:24. Observe how a change in wages and resource prices is the key mechanism that shifts the SRAS curve to restore long-run equilibrium.
The key insight is that the economy has a natural tendency to return to its potential output level. The adjustment, however, happens through the SRAS curve, driven by changes in input prices.
Conclusion
In this lesson, we assembled the full AD-AS model and used it to diagnose the state of an economy. This framework is central to macroeconomics and will be the foundation for our upcoming discussions on fiscal and monetary policy.
Key Takeaways:
- Short-run equilibrium is determined by the intersection of the AD and SRAS curves, setting the current price level and real GDP.
- Long-run equilibrium occurs when all three curves (AD, SRAS, LRAS) intersect. Here, the economy is at potential GDP with unemployment at its natural rate.
- A recessionary gap exists when short-run equilibrium output is below potential GDP (), leading to high unemployment.
- An inflationary gap exists when short-run equilibrium output is above potential GDP (), leading to low unemployment and rising inflation.
- Over time, the economy has a self-correcting mechanism: changes in nominal wages and other input prices will shift the SRAS curve to close these gaps and return the economy to its long-run potential output.
Preview of the Next Lesson:
We now understand what equilibrium looks like and how the economy behaves when it's out of long-run balance. But what causes these gaps in the first place? In our next lesson, we will analyze the effects of economic "shocks"—sudden events that shift the Aggregate Demand or Short-Run Aggregate Supply curves—and see how they impact the price level and real GDP in the short run.