Put AD and AS on the same axes and they cross at one point. That point tells you the average price level and the real output of the whole economy. Compare it with what the economy could produce and you have an output gap — the single most useful idea for judging whether an economy is running too cold or too hot.
📚 What you need to know
Short-run equilibrium is where AD crosses SRAS. It gives the price level and real output right now.
Long-run equilibrium (classical) is where AD, SRAS and LRAS all meet, at YFE.
An output gap is the difference between actual real GDP and potential real GDP.
Negative (deflationary/recessionary) gap: actual output is below potential — spare capacity and high unemployment.
Positive (inflationary) gap: actual output is above potential — overtime, shortages and rising prices.
Classical economists say gaps close automatically; Keynesians say a negative gap can last for years.
Where the economy settles
The logic is the same as any market. If AD is greater than what firms will supply, stocks run down and prices are bid up. If firms supply more than buyers want, stocks pile up and prices are cut. Only where the two lines cross is there no pressure to change.
Above the crossing point, firms want to supply more than buyers want to buy. Below it, buyers want more than firms will produce. Both push the economy back to the crossing point.
Output gaps
Equilibrium tells you where the economy is. Add the LRAS line and you can see where it could be. The distance between the two is the output gap.
Output gap
Output gap = actual real GDP − potential real GDP
Both panels are drawn classically. On a Keynesian diagram a negative gap looks the same idea, but the equilibrium sits on the flat or rising section of the AS curve.
Feature
Negative output gap
Positive output gap
Actual output
Below potential
Above potential
Unemployment
High, above the natural rate
Very low, below the natural rate
Inflation pressure
Weak; prices may even fall
Strong; demand-pull inflation
Spare capacity
Plenty of idle machines and workers
None — overtime and shortages
Typical cause
A fall in AD, often a recession
A rapid rise in AD
Is it sustainable?
It is wasteful but it can persist
No — you cannot run flat out forever
A positive output gap sounds like good news, and students often write that it is. It is not sustainable. Working every machine and every worker beyond the normal level is like sprinting: possible for a while, expensive afterwards.
How the classical model closes a gap by itself
🧩 Closing a negative gap without the government
AD falls, so output drops below YFE and prices fall a little.
Firms need fewer workers, so they lay people off.
Unemployed workers eventually accept lower wages.
Lower wages cut costs of production, so SRAS shifts right.
Output returns to YFE, at a lower average price level.
🧩 Closing a positive gap without the government
AD rises, so output goes above YFE and prices rise.
Workers see their real wages falling and demand higher pay.
Resources are scarce, so firms have to agree.
Higher wages raise costs, so SRAS shifts left.
Output returns to YFE, at a higher average price level.
The Keynesian objection. Step 3 of the first recipe is the weak link. If wages will not fall — because of minimum wage laws, unions or contracts — SRAS never shifts right and the economy stays stuck. That is the case for government intervention.
Worked example
WORKED EXAMPLE
Measuring the gap
An economy has potential real GDP of $500 billion. Actual real GDP is $470 billion. Calculate the output gap in dollars and as a percentage of potential output, and say what type of gap it is.
Step 1: use the definitionGap = actual − potential = 470 − 500Gap = −$30 billionStep 2: express it as a percentage(−30 ÷ 500) × 100 = −6%Step 3: interpret itA negative output gap of 6% of potential GDPThe economy is producing 6% less than it could, so expect high unemployment and weak inflation.
💡 Exam tip
Equilibrium needs two answers: the average price level and real output. Give both.
Draw the LRAS line whenever the question mentions full employment, potential output or an output gap.
Show the gap as a clear horizontal distance and label it. A vague arrow will not do.
Use the right words: negative gap = deflationary = recessionary; positive gap = inflationary.
For evaluation, ask how big the gap is and how long it has lasted before recommending a policy.
Output gaps are hard to measure because nobody knows potential output exactly — a strong evaluation point.
⚠️ Common mix-up
Calling an inflationary output gap “inflation”. An output gap is about output. Inflation is about prices.
Thinking a positive gap is a good thing. It is unsustainable and it drives up inflation.
Getting the sign backwards. Actual below potential is negative, even though unemployment is high.
Forgetting LRAS. Without it there is nothing to compare actual output to, so there is no gap to show.
Assuming gaps close instantly. Even classical economists only claim it happens in the long run.
Measuring the gap vertically. It is a difference in output, so it is measured along the horizontal axis.
Up next: The Government’s Macroeconomic Aims — the four things every finance minister is judged on, and why they cannot all be achieved at once.
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