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3.5 Equilibrium in Aggregate Demand-Aggregate Supply (AD-AS) Model

3 min readdecember 30, 2022

J

Jeanne Stansak

Haseung Jun

Haseung Jun

J

Jeanne Stansak

Haseung Jun

Haseung Jun

Equilibrium AD-AS Model

Aggregate equilibrium is very similar to equilibrium with demand and supply for an individual good or service. There are two types of equilibrium when we are referring to the aggregate economy. Short-run aggregate equilibrium occurs when the quantity of aggregate demanded is equal to the . This is displayed on a graph by the intersection of and aggregate demand (AD). If you took micro, this'll look familiar.

occurs when the current output is also equal to potential output. This is demonstrated by the intersection of , AD, and LRAS. This is also referred to as the .

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-iA3OElw7exU9.png?alt=media&token=3da131e7-b6c5-408f-ba71-62a486d76b31

Equilibrium Gaps

If the price level increases above equilibrium, then you have a . This means that your aggregate supply is greater than your aggregate demand. If the price level decreases below equilibrium, then you have a . This means that your aggregate demand is greater than your aggregate supply.

The can be at the , above it or below it. If the short-run equilibrium is below it, then it creates what we cause a (negative output gap). If the short-run equilibrium is above it, it creates what we cause an inflationary gap (positive output gap).

These graphs become super important on the AP exam, so it's recommended that you fully understand these graphs! Just remember that when AD and intersect but it's to the left of LRAS, it's a because the intersection is "falling behind". Similarly, when the intersection is to the right of LRAS, it's an inflationary gap because the intersection is "moving ahead".

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-ytIYu2TdBiZW.png?alt=media&token=9a984db8-e33a-495f-8525-a9909637f6a3

Inflationary Gap

An inflationary gap is a condition where an economy is producing a short-run Real GDP output that is beyond its . At first, it might seem like a good thing that we have a lot of production going on right? But the key to economics is this: equilibrium! This type of situation can lead to an , which drives prices up and eventually decreases , which will cause a contraction of the economy. In an inflationary gap, the economy is producing more than the potential Real GDP and their unemployment levels are lower than what is considered full employment (4-6%). The United States economy experienced an inflationary gap in 2006 when its economy was booming, there was low unemployment, wage rates increased, and more households had a larger amount of disposable income and higher purchasing power.

Recessionary Gap

A is a condition where an economy is producing a short-run Real GDP output that is less than its potential Real GDP at full employment. This type of situation leads to the economy producing below its potential, and unemployment increases, and income levels, consumption, and the standard of living decreases. In a , the economy is producing less than the potential Real GDP, and their unemployment levels are higher than what is considered full employment (4-6%). The U.S. economy saw a in 2005 when the potential GDP was 66.86 billion but the real GDP was only 17.95 billion.

Fixes

So how would we fix these gaps? 😊 If I tell you now, it would be a spoiler for topic 3.7 and 3.8!

A quick sneak peak: either we can let the economy fix itself or let the government handle it through 😆 Ever heard of those!?

Key Terms to Review (20)

Aggregate demand (AD)

: Aggregate demand refers to the total amount of goods and services that all sectors in an economy are willing and able to purchase at different price levels during a given time period.

Aggregate demand greater than aggregate supply

: When total demand for goods and services in an economy surpasses the total supply available, leading to scarcity. This can result in increased prices and production levels.

Aggregate supply greater than aggregate demand

: When the total supply of goods and services in an economy exceeds the total demand for them, resulting in a surplus. This can lead to decreased prices and production levels.

Consumer purchasing power and consumption

: Consumer purchasing power refers to the ability of consumers to buy goods and services based on their income levels. Consumption refers to spending by individuals on final goods and services for personal use.

Equilibrium AD-AS Model

: The Equilibrium AD-AS (Aggregate Demand-Aggregate Supply) model is a graphical representation of the macroeconomy that shows the relationship between aggregate demand and aggregate supply. It helps to analyze how changes in these factors can affect output, price levels, and economic growth.

Equilibrium Gaps

: Equilibrium gaps refer to situations where there is a difference between the actual level of economic activity and the desired or potential level.

Fiscal Policy

: Fiscal policy refers to the government's use of taxation and spending to influence the economy. It involves decisions on how much money the government should collect in taxes and how much it should spend on public goods and services.

Full-employment level of real output

: The full-employment level of real output refers to the point at which an economy is producing its maximum potential output, with all available resources being utilized efficiently.

Full-employment of output

: Full-employment of output refers to the situation when an economy is producing at its potential GDP, utilizing all available resources efficiently without any cyclical unemployment.

Inflationary gap (positive output gap)

: An inflationary gap refers to the situation when the actual level of Real GDP exceeds the potential level of Real GDP, leading to upward pressure on prices in the economy.

Long-run Equilibrium

: Long-run equilibrium occurs when the aggregate demand is equal to the aggregate supply in an economy, resulting in stable prices and full employment over time.

Overheating economy

: An overheating economy occurs when economic growth becomes unsustainable due to excessive demand leading to inflationary pressures.

Potential Real GDP output at full employment

: Potential Real GDP output at full employment refers to the maximum level of production an economy can achieve when all resources are fully utilized, including labor, capital, and technology.

Quantity of aggregate supply

: The quantity of aggregate supply refers to the total amount of goods and services that all firms in an economy are willing and able to produce at a given price level during a specific time period.

Recessionary Gap

: A recessionary gap occurs when the actual level of output in an economy is below its potential level, resulting in high unemployment and underutilization of resources.

Recessionary gap (negative output gap)

: A recessionary gap, also known as a negative output gap, occurs when the actual level of output falls below the potential GDP due to insufficient aggregate demand.

Short-run equilibrium output

: The short-run equilibrium output refers to the level of production in an economy where aggregate demand (AD) is equal to aggregate supply (AS) in the short run.

Shortage in GDP

: A situation where the gross domestic product (GDP) falls short of its potential level due to insufficient aggregate demand. It indicates an underutilization of resources within an economy.

SRAS

: SRAS stands for short-run aggregate supply. It represents the total amount of goods and services that all firms in an economy are willing and able to produce at different price levels during a specific time period when some input prices remain fixed.

Surplus in GDP

: Surplus in GDP refers to a situation where an economy's gross domestic product (GDP) exceeds its total spending or aggregate demand.

3.5 Equilibrium in Aggregate Demand-Aggregate Supply (AD-AS) Model

3 min readdecember 30, 2022

J

Jeanne Stansak

Haseung Jun

Haseung Jun

J

Jeanne Stansak

Haseung Jun

Haseung Jun

Equilibrium AD-AS Model

Aggregate equilibrium is very similar to equilibrium with demand and supply for an individual good or service. There are two types of equilibrium when we are referring to the aggregate economy. Short-run aggregate equilibrium occurs when the quantity of aggregate demanded is equal to the . This is displayed on a graph by the intersection of and aggregate demand (AD). If you took micro, this'll look familiar.

occurs when the current output is also equal to potential output. This is demonstrated by the intersection of , AD, and LRAS. This is also referred to as the .

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-iA3OElw7exU9.png?alt=media&token=3da131e7-b6c5-408f-ba71-62a486d76b31

Equilibrium Gaps

If the price level increases above equilibrium, then you have a . This means that your aggregate supply is greater than your aggregate demand. If the price level decreases below equilibrium, then you have a . This means that your aggregate demand is greater than your aggregate supply.

The can be at the , above it or below it. If the short-run equilibrium is below it, then it creates what we cause a (negative output gap). If the short-run equilibrium is above it, it creates what we cause an inflationary gap (positive output gap).

These graphs become super important on the AP exam, so it's recommended that you fully understand these graphs! Just remember that when AD and intersect but it's to the left of LRAS, it's a because the intersection is "falling behind". Similarly, when the intersection is to the right of LRAS, it's an inflationary gap because the intersection is "moving ahead".

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-ytIYu2TdBiZW.png?alt=media&token=9a984db8-e33a-495f-8525-a9909637f6a3

Inflationary Gap

An inflationary gap is a condition where an economy is producing a short-run Real GDP output that is beyond its . At first, it might seem like a good thing that we have a lot of production going on right? But the key to economics is this: equilibrium! This type of situation can lead to an , which drives prices up and eventually decreases , which will cause a contraction of the economy. In an inflationary gap, the economy is producing more than the potential Real GDP and their unemployment levels are lower than what is considered full employment (4-6%). The United States economy experienced an inflationary gap in 2006 when its economy was booming, there was low unemployment, wage rates increased, and more households had a larger amount of disposable income and higher purchasing power.

Recessionary Gap

A is a condition where an economy is producing a short-run Real GDP output that is less than its potential Real GDP at full employment. This type of situation leads to the economy producing below its potential, and unemployment increases, and income levels, consumption, and the standard of living decreases. In a , the economy is producing less than the potential Real GDP, and their unemployment levels are higher than what is considered full employment (4-6%). The U.S. economy saw a in 2005 when the potential GDP was 66.86 billion but the real GDP was only 17.95 billion.

Fixes

So how would we fix these gaps? 😊 If I tell you now, it would be a spoiler for topic 3.7 and 3.8!

A quick sneak peak: either we can let the economy fix itself or let the government handle it through 😆 Ever heard of those!?

Key Terms to Review (20)

Aggregate demand (AD)

: Aggregate demand refers to the total amount of goods and services that all sectors in an economy are willing and able to purchase at different price levels during a given time period.

Aggregate demand greater than aggregate supply

: When total demand for goods and services in an economy surpasses the total supply available, leading to scarcity. This can result in increased prices and production levels.

Aggregate supply greater than aggregate demand

: When the total supply of goods and services in an economy exceeds the total demand for them, resulting in a surplus. This can lead to decreased prices and production levels.

Consumer purchasing power and consumption

: Consumer purchasing power refers to the ability of consumers to buy goods and services based on their income levels. Consumption refers to spending by individuals on final goods and services for personal use.

Equilibrium AD-AS Model

: The Equilibrium AD-AS (Aggregate Demand-Aggregate Supply) model is a graphical representation of the macroeconomy that shows the relationship between aggregate demand and aggregate supply. It helps to analyze how changes in these factors can affect output, price levels, and economic growth.

Equilibrium Gaps

: Equilibrium gaps refer to situations where there is a difference between the actual level of economic activity and the desired or potential level.

Fiscal Policy

: Fiscal policy refers to the government's use of taxation and spending to influence the economy. It involves decisions on how much money the government should collect in taxes and how much it should spend on public goods and services.

Full-employment level of real output

: The full-employment level of real output refers to the point at which an economy is producing its maximum potential output, with all available resources being utilized efficiently.

Full-employment of output

: Full-employment of output refers to the situation when an economy is producing at its potential GDP, utilizing all available resources efficiently without any cyclical unemployment.

Inflationary gap (positive output gap)

: An inflationary gap refers to the situation when the actual level of Real GDP exceeds the potential level of Real GDP, leading to upward pressure on prices in the economy.

Long-run Equilibrium

: Long-run equilibrium occurs when the aggregate demand is equal to the aggregate supply in an economy, resulting in stable prices and full employment over time.

Overheating economy

: An overheating economy occurs when economic growth becomes unsustainable due to excessive demand leading to inflationary pressures.

Potential Real GDP output at full employment

: Potential Real GDP output at full employment refers to the maximum level of production an economy can achieve when all resources are fully utilized, including labor, capital, and technology.

Quantity of aggregate supply

: The quantity of aggregate supply refers to the total amount of goods and services that all firms in an economy are willing and able to produce at a given price level during a specific time period.

Recessionary Gap

: A recessionary gap occurs when the actual level of output in an economy is below its potential level, resulting in high unemployment and underutilization of resources.

Recessionary gap (negative output gap)

: A recessionary gap, also known as a negative output gap, occurs when the actual level of output falls below the potential GDP due to insufficient aggregate demand.

Short-run equilibrium output

: The short-run equilibrium output refers to the level of production in an economy where aggregate demand (AD) is equal to aggregate supply (AS) in the short run.

Shortage in GDP

: A situation where the gross domestic product (GDP) falls short of its potential level due to insufficient aggregate demand. It indicates an underutilization of resources within an economy.

SRAS

: SRAS stands for short-run aggregate supply. It represents the total amount of goods and services that all firms in an economy are willing and able to produce at different price levels during a specific time period when some input prices remain fixed.

Surplus in GDP

: Surplus in GDP refers to a situation where an economy's gross domestic product (GDP) exceeds its total spending or aggregate demand.


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© 2024 Fiveable Inc. All rights reserved.

AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.