Equilibrium in the AD-AS Model

Equilibrium in the AD-AS model works the same way any supply-and-demand crossing works: at the intersection, the quantity of total output buyers want to purchase matches the quantity producers are willing to sell at that price level. Draw the price level on the vertical axis and real GDP on the horizontal axis. AD slopes downward, SRAS slopes upward, and a vertical LRAS line marks potential output, the economy's full-employment GDP. Wherever AD crosses SRAS gives the short-run equilibrium price level and output level today.

That crossing does not have to sit on LRAS. SRAS is built on sticky wages and input costs that take time to adjust, so firms respond to price changes in the short run even when the economy is above or below full employment. If AD crosses SRAS to the right of LRAS, output exceeds potential and an inflationary gap exists. If it crosses to the left, a recessionary gap exists with unemployment above its natural rate. Only when AD happens to cross SRAS right on the LRAS line does the economy sit at full employment with no output gap.

This single AD-AS picture is a snapshot, and it maps directly onto one point on a business-cycle chart that plots real GDP over time against a long-run potential-output trend. A recessionary gap is a point below that trend, an inflationary gap is a point above it, and equilibrium exactly on LRAS is a point sitting right on the trend line itself. The next step in the unit is how fiscal policy shifts AD to try to close whichever gap is showing.