Put the three curves together: AD, SRAS and LRAS. Where AD meets SRAS is the short-run equilibrium. Comparing it with LRAS tells you where the economy sits in the The Business Cycle.
Key idea
Short-run equilibrium is where AD = SRAS. If equilibrium output is below full-employment output (left of LRAS), there is a recessionary gap; if it is above (right of LRAS), an inflationary gap. Long-run equilibrium is where all three curves meet.
Why it works
At the AD–SRAS crossing, the output buyers want equals the output firms want to produce at that price level, so there is no pressure to change. But that output need not equal potential. Below potential, workers are idle and cyclical unemployment is high. Above potential, firms run overtime and labor is scarce, unemployment is below its natural rate, and wages and prices are pushed up.
Worked examples
Worked example: Naming the gap
Full-employment output is \$20 trillion. Short-run equilibrium output is \$21 trillion.
- Equilibrium is to the right of LRAS: output is above potential.
- An inflationary gap of \$1 trillion; unemployment is below its natural rate.
Answer: Inflationary gap, \$1 trillion
Worked example: Solving with equations
AD: $P = 200 - 5Y$ and SRAS: $P = 80 + 5Y$ ($Y$ in trillions). Full-employment output is 13. Find equilibrium.
- Set them equal: $200 - 5Y = 80 + 5Y$, so $120 = 10Y$ and $Y = 12$.
- $P = 200 - 5(12) = 140$.
- $12 < 13$: a recessionary gap of \$1 trillion.
Answer: $Y = 12$, $P = 140$; recessionary gap
The gaps also tell you about jobs. Fewer goods and services take fewer workers, so a recessionary gap comes with unemployment above its natural rate; an inflationary gap comes with unemployment below it, and with wages and prices under upward pressure. The next lessons show what happens to a gap over time, and what policy can do about it.
Common mistake
Mixing up the gaps, for example calling output above full employment a recessionary gap. Check: "recessionary" goes with less output and more unemployment, so it must be left of LRAS; "inflationary" goes with overheating, right of LRAS.