Chapter 9 · Aggregate demand and aggregate supply
Long-run macroeconomic equilibrium
Locate long-run equilibrium where AD, SRAS and LRAS meet. Distinguish potential output from a short-run equilibrium with an output gap.
The economic idea
The monetarist/new classical model assumes that the economy has a potential level of output determined by the quantity and quality of productive resources, technology and institutions. In the long run, the average price level does not determine this productive capacity.
Long-run aggregate supply is therefore vertical at potential output. It shows the real output the economy can produce sustainably when labour and other resources are employed at their normal full-employment rates.
Short-run macroeconomic equilibrium occurs where aggregate demand intersects short-run aggregate supply. A long-run equilibrium occurs only when that intersection is also on LRAS, so actual output equals potential output.
An output gap is the difference between actual real GDP and potential real GDP. A recessionary gap exists when actual output is below potential; an inflationary gap exists when actual output is above its sustainable level.
In the long run, flexible nominal wages, input prices and expectations adjust to remove an output gap. Aggregate demand can determine the price level, but it cannot keep real output permanently away from potential output in this model.
Reading long-run equilibrium from E and LRAS
“Price level” measures the average price level and “Real GDP” measures real GDP.
“AD” and “SRAS” determine the short-run equilibrium “E”, with price level “PLₑ” and actual output “Yₑ”.
“LRAS” is vertical at potential output. Its horizontal position, not its height, is the benchmark for sustainable productive capacity.
Short-run position: E
“E” is the intersection of “AD” and “SRAS”. It is the point at which planned expenditure equals firms' short-run planned output.
Long-run benchmark: LRAS
“LRAS” marks potential output. Moving the price level up or down does not move the economy along this vertical curve because long-run output is governed by productive capacity rather than the average price level.
The gap shown now
“E” lies on “LRAS”. Actual output “Yₑ” equals potential output, so the economy is in short-run and long-run macroeconomic equilibrium at “PLₑ”.
Full employment still includes some unemployment
Full-employment output is a sustainable level of production, not a claim that unemployment is zero. People can still be between jobs or lack the skills needed for available vacancies.
In this model, changing nominal spending alone cannot permanently raise output beyond LRAS. A lasting increase in potential output needs more or better productive resources, technology or institutions.
How the output gap creates its own adjustment pressure
“AD”, “SRAS” and “LRAS” meet at “E”. Actual output therefore equals potential output.
There is neither general spare-capacity pressure pushing input prices down nor economy-wide excess-demand pressure pushing them up.
Without a new shock, there is no systematic reason for SRAS to shift in order to close an output gap.
Common mistakes to avoid
- The intersection of “AD” and “SRAS” is always a short-run equilibrium, but it is a long-run equilibrium only when it lies on “LRAS”.
- Full employment does not mean zero unemployment. Frictional and structural unemployment can remain at potential output.
- A recessionary gap is a shortfall of actual output below potential output, not a shaded welfare loss or the size of a fall in GDP over time.
- An inflationary gap does not mean the economy can sustain extra output forever; it represents output above its normal sustainable level.
- A change in the price level does not shift “LRAS”. Productive resources, technology and institutions determine its position.
How to draw this diagram
- Title the diagram “Long-run macroeconomic equilibrium”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw SRAS next and label it clearly.
- Draw LRAS next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- Potential output cannot be observed directly and must be estimated, so the measured output gap is uncertain.
- Nominal wages and input prices may be sticky because of contracts, minimum wages, bargaining, morale and imperfect information.
- A prolonged recession can reduce investment and skills, shifting potential output left through hysteresis rather than leaving LRAS fixed.
- An inflationary period can induce investment, migration or participation changes that alter capacity rather than producing only price adjustment.
- The aggregate model hides sectoral bottlenecks and regional unemployment that can coexist within the same national output gap.