Everything in this topic has been building to one diagram. Put AD and AS on the same axes and you get the economy’s price level and its level of output. Add the full employment line and you can see something more interesting: whether the economy is where it should be, and what happens next if it is not.
📘 What you need to know
Short-run equilibrium is where AD meets SRAS. It gives the average price level and real output.
Long-run equilibrium in the classical model is where AD, SRAS and LRAS all cross, at YFE.
A negative (deflationary or recessionary) output gap is when real GDP is below potential output.
A positive (inflationary) output gap is when real GDP is above potential output.
The classical self-correcting mechanism closes both gaps through changes in wages, and therefore in SRAS.
Keynesians argue the economy can be stuck below full employment, because wages do not fall.
An inflationary output gap is about output, not about inflation itself. Do not confuse the two.
Short-run equilibrium
Where AD crosses SRAS the economy has an average price level and a level of real output. Move either curve and both of those change.
This is where the economy actually is. Any change to a component of AD shifts the AD curve and creates a new short-run equilibrium. Any change to costs of production or indirect taxes shifts SRAS and does the same. Nothing here tells you whether the economy is doing well, because there is no benchmark on the diagram yet.
That benchmark is LRAS. Adding the vertical line at YFE gives you something to compare the equilibrium against.
Output gaps
One economy, one potential output, two entirely different situations depending on where aggregate demand sits.
Negative (recessionary) gap
Positive (inflationary) gap
Where equilibrium sits
To the left of YFE
To the right of YFE
Capacity
Spare capacity, idle factories
Producing beyond the sustainable level
Unemployment
High, above the natural rate
Very low, firms competing for workers
Prices
Weak inflation, sometimes falling prices
Strong upward pressure on prices
Usual cause
A fall in AD, for example a collapse in confidence
A rise in AD, for example rapid credit growth
How it is sustained
It is not sustained, it just persists
Overtime and pushing equipment hard, so it cannot last
The name causes real confusion, so be precise. An inflationary output gap is a statement about output: the economy is producing beyond its full employment level. It is called inflationary because that situation generates inflation, but the gap itself is measured in output, not in prices. Students who write that an inflationary gap means prices have risen lose the mark.
How the classical model closes a recessionary gap
Nobody decided any of this. Falling demand causes unemployment, unemployment lowers wages, lower wages lower costs, and lower costs bring output back.
🧩 The correction process, step by step
The economy starts in long-run equilibrium at AP1 and YFE.
AD falls from AD1 to AD2, perhaps because a recession has begun abroad or confidence has collapsed.
Output falls to Y1 and the price level falls to AP2. A negative output gap has opened.
With less to produce, firms lay off workers, so unemployment rises.
Unemployed workers eventually accept lower wages, which reduces firms’ costs of production.
Lower costs shift SRAS right from SRAS1 to SRAS2.
A new long-run equilibrium forms at YFE and AP3: full employment restored, at a lower price level.
The inflationary gap works the same way in reverse. AD rises above YFE, the tight labour market lets workers demand higher wages, costs rise, SRAS shifts left, and output returns to YFE at a higher price level.
The pattern to memorise: in the classical model the economy always ends up back at YFE. What changes is the price level. A recessionary gap ends at a lower price level; an inflationary gap ends at a higher one.
The Keynesian objection
Everything above depends on step 5: unemployed workers accepting lower wages. Keynesians argue this is exactly what does not happen, because of minimum wage laws, union agreements and long-term contracts, and because there is a point below which people will not go.
If wages do not fall, costs do not fall, SRAS does not shift, and the economy has no mechanism to get back to full employment. It can settle in the flat section of the Keynesian AS curve and stay there for years, with high unemployment and no natural way out. The Great Depression is the standard example.
The low output then feeds on itself. High unemployment means low confidence, low confidence means less investment and less consumption, and AD falls further. That is why Keynes argued government spending was necessary: something outside the loop had to break into it.
A fair judgement, and the one strong answers reach: the classical mechanism is not wrong, it is slow and uncertain. The real disagreement is about how long an economy should be left to fix itself, and how much unemployment is acceptable while it does. That is a question about values as much as about economics.
WORKED EXAMPLE
An economy is in long-run equilibrium. Consumer confidence collapses. Using a classical diagram, explain the short-run and long-run effects. [4]
Step 1: the initial effectC falls, so AD shifts left from AD₁ to AD₂Step 2: the short runOutput falls below YFE and the price level falls. A negative output gap has opened and unemployment rises.Step 3: the adjustmentunemployment pushes wages down, costs fall, SRAS shifts rightStep 4: the long runOutput returns to YFE at a lower average price levelSay how long you think this takes, and the marks for evaluation open up.
WORKED EXAMPLE
Potential output is $920 billion and the economy is producing $985 billion. Identify the output gap, calculate it as a percentage, and state two likely consequences. [4]
Step 1: which gap is it?985 − 920 = +65, so actual output is above potentialA positive, inflationary output gap of $65 billionStep 2: as a percentage of potential(65 ÷ 920) × 100 = 7.07%Step 3: consequences
Unemployment falls below its natural rate, and firms competing for scarce workers bid wages up.
Rising wages raise costs, so demand-pull inflation is followed by cost-push pressure and the position cannot be sustained.
💡 Exam tip
Always mark YFE. Without it you cannot show an output gap at all.
Show the sequence, not just the end point. AD shifts first, SRAS responds afterwards, and the order is where the marks are.
Number your steps on the diagram. It makes a long chain much easier for an examiner to follow.
Name the gap using both terms: negative or recessionary, positive or inflationary.
Give the Keynesian objection whenever you use the classical adjustment. It is the built-in evaluation.
Keep the price level in your answer. Every one of these adjustments ends at a different price level, and students forget to say so.
⚠️ Common mix-up
Thinking an inflationary gap means inflation is high. It means output is above the full employment level.
Shifting AD back to close the gap. The classical mechanism works through SRAS, driven by wages.
Forgetting to mark the new price level. The whole point is that output returns and the price level does not.
Assuming self-correction is quick. Nothing in the model says how long it takes, and that is the central criticism.
Confusing the business cycle diagram with an AD/AS diagram. One has time on the horizontal axis, the other has real GDP.
Drawing three curves without labelling them. AD, SRAS and LRAS all need labels, and so do both axes.
That completes the AD/AS model. Before you move on, test yourself: draw a recessionary gap, correct it the classical way, then explain in two sentences why a Keynesian would not expect that to happen. If you can do that from memory, you are ready for any question in this sub-topic.
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