Lesson preview · Macro Equilibrium
Macro Equilibrium
~12 min · Free to read
You now have three curves. Aggregate demand (AD) slopes down — total planned spending by households, firms, government, and foreigners. Short-run aggregate supply (SRAS) slopes up, because wages are sticky. Long-run aggregate supply (LRAS) stands vertical at potential output, the amount the economy makes at full employment. Three lines on one chart. So where does the economy actually settle?
It settles where the curves cross. Like any market, the economy comes to rest at the price level and output where the buyers’ line and the sellers’ line meet. The whole job now is to read that crossing point — and to see why the economy will not stay there if it sits in the wrong place.
Key Term
Short-run equilibrium — where AD meets SRAS
Short-run equilibrium is the point where the aggregate demand curve crosses the short-run aggregate supply curve. That single crossing fixes two things at once:
- the short-run price level — read it off the vertical axis;
- the short-run real GDP — read it off the horizontal axis.
It is exactly like a normal market clearing. Where the downward AD line and the upward SRAS line intersect, total spending equals total production, and the economy comes to rest there for now.
Key Term
Long-run equilibrium — output at potential
Long-run equilibrium is the point where aggregate demand crosses long-run aggregate supply (LRAS). Because LRAS is vertical at potential output — the full-employment level — long-run equilibrium means output equals potential, no more and no less.
The economy is in full long-run equilibrium only when all three curves pass through the same point: AD, SRAS, and LRAS all meet. Then the short-run crossing and the long-run anchor agree, and there is no pressure to change.
Key Term
Output gaps — recessionary vs inflationary
When short-run output does not match potential, the economy sits in an output gap:
- A recessionary gap — short-run equilibrium output is below potential. Factories run idle and unemployment sits above its normal level.
- An inflationary gap — short-run equilibrium output is above potential. The economy is overheating: labour and materials are scarce and prices are being bid up.
Name the gap by comparing the short-run crossing to the vertical LRAS. To the left of LRAS, recessionary. To the right of LRAS, inflationary.
Key Term
Self-correction — the gap closes by itself
The economy does not stay in a gap forever, even if nobody does anything. It self-corrects, and the curve that moves is SRAS — not AD.
- In a recessionary gap, output is below potential and unemployment is high. Workers compete for scarce jobs, so wages and other input costs drift down. Lower costs let firms produce more at every price level, so SRAS shifts right. Output rises back to potential while the price level falls.
- In an inflationary gap, output is above potential and labour is scarce. Workers bid wages up and input costs climb. Higher costs cut what firms produce at every price level, so SRAS shifts left. Output falls back to potential while the price level rises.
Either way, output ends up at potential — the long-run equilibrium. The gap closes through SRAS sliding, not through AD moving.
That is the takeaway. The economy self-corrects to potential output because SRAS shifts to close any gap. Whatever the short run looked like — a slump or a boom — the long-run equilibrium always lands back at potential.
Trap · Common Misconception
"The economy is stuck in a recession until the government acts"
It feels as if a slump can only end when the government steps in to spend. Not so. Even with no policy at all, self-correction drags output back toward potential: high unemployment pushes wages and input costs down, SRAS shifts right, and the recessionary gap closes on its own. Government action can speed up that adjustment — and the wait can be long and painful, which is the real argument for policy — but the long-run anchor is always potential output, with or without intervention. The economy does not need a rescue to eventually return to potential; it needs one to get there faster.
Both paths end at potential output — what policy buys is time, and the price level you settle at.
Check yourself · no marks
An economy’s short-run equilibrium output is above potential. Which way does SRAS shift over time, and what happens to the price level?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
An economy has potential output of 100. Its short-run equilibrium — where aggregate demand crosses short-run aggregate supply — sits at output 92. No policy is taken. (1) Name the gap. (2) Describe what self-correction does to wages and to SRAS. (3) Say where output ends up and what happens to the price level along the way.
Practice · 1 / 4
What determines an economy’s short-run equilibrium price level and real GDP?
Next
Like what you read?
Sign up free to save your progress, get spaced reviews tuned to you, and unlock all 50 microeconomics knowledge points with interactive graphs and adaptive practice.