Chapter 9 · Aggregate demand and aggregate supply
Recessionary gap
Identify a recessionary gap in the AD–AS model. Compare actual real GDP with potential output and explain demand-deficient unemployment.
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.
A recessionary gap indicates spare capacity and cyclical unemployment. Weak planned expenditure leaves firms with insufficient sales to employ all available resources at their normal rates.
Reading recessionary gap 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 to the left of “LRAS”, so “Yₑ” is below potential output. The current graph shows a recessionary gap: resources are underused and cyclical unemployment is present.
A negative output gap is a level comparison
An economy can be recovering and still have a recessionary gap. Real GDP may be increasing from one year to the next while remaining below the output it could produce sustainably.
The gap supports a claim about unused capacity and cyclical unemployment. It does not show that every unemployed person could immediately fill an available job; structural and frictional unemployment can exist as well.
How the output gap creates its own adjustment pressure
At “E”, output is below the position of “LRAS”, so labour and other resources are underused.
Weak demand for labour and inputs places downward pressure on nominal wages and other production costs, although contracts and expectations can make this slow.
Lower unit costs increase short-run aggregate supply, shifting “SRAS” right/down until the AD–SRAS intersection reaches “LRAS”.
Real output returns to potential while the price level falls, assuming aggregate demand and productive capacity do not change.
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 “Recessionary gap”. 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.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- 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.