Difficulty: Intermediate | Prerequisites: Aggregate demand (Topic 3.1), SRAS and LRAS (Topics 3.3–3.4).
This is where the model comes together. You have learned about AD, SRAS, and LRAS as individual curves. Now you put them on the same graph and see what happens when they interact. Topic 3.5 defines macroeconomic equilibrium and the three possible states the economy can be in. Topic 3.6 covers what happens when shocks hit, including two types of inflation. Topic 3.7 explains the economy's built-in correction mechanism over time. This cluster of topics is the analytical core of Unit 3 and the most heavily tested portion of the AD-AS model on the AP exam.
The economy is in equilibrium where AD and SRAS intersect. That equilibrium may be at, above, or below full-employment output, creating three possible scenarios. Demand shocks and supply shocks cause different types of inflation and different problems. In the long run, wages adjust and the economy self-corrects back to full employment without any government intervention.
Macroeconomic Equilibrium
The point where aggregate demand (AD) and short-run aggregate supply (SRAS) intersect. This determines the economy's price level and real GDP in the short run. Think of it as: the price level and output the economy settles at when total spending meets total production.
Full Employment Equilibrium
When the AD-SRAS equilibrium happens to occur exactly at the LRAS (full-employment output). The economy is producing at its potential, with no output gap.
Inflationary Gap (Positive Output Gap)
When the AD-SRAS equilibrium is to the right of the LRAS, meaning the economy is producing beyond its long-run sustainable capacity. Real GDP exceeds potential GDP. Unemployment is below the natural rate, and there is upward pressure on prices.
Recessionary Gap (Negative Output Gap)
When the AD-SRAS equilibrium is to the left of the LRAS, meaning the economy is producing below its potential. Real GDP is less than potential GDP. Unemployment is above the natural rate, and there is downward pressure on prices (or at least disinflation).
Demand-Pull Inflation
Inflation caused by an increase in aggregate demand. Demand "pulls" prices up because consumers and firms are competing for goods and services. On the graph, AD shifts right, pushing both the price level and real GDP higher.
Cost-Push Inflation
Inflation caused by a decrease in short-run aggregate supply. Rising production costs "push" prices up. On the graph, SRAS shifts left, pushing the price level higher while real GDP falls.
Stagflation
The combination of economic stagnation (falling output) and inflation (rising prices). Occurs when SRAS decreases, creating a situation where the economy contracts and prices rise simultaneously. This is still classified as a recessionary gap.
Long-Run Self-Adjustment
The process by which the economy returns to full-employment output over time without government intervention. In a recessionary gap, wages eventually fall (workers accept lower pay as unemployment persists), shifting SRAS right and restoring full employment. In an inflationary gap, wages eventually rise (workers demand higher pay in a tight labour market), shifting SRAS left and restoring full employment.
Economic Growth
A sustained increase in the economy's capacity to produce goods and services. Represented by a rightward shift of both the LRAS and the PPC. Caused by increases in capital stock, labour force, or technology.
All three use the same graph: AD, SRAS, and LRAS drawn together with Price Level on the vertical axis and real GDP on the horizontal axis.
At full employment: AD and SRAS intersect exactly on the LRAS line. The economy is at potential GDP (Yf). No gap exists.
Inflationary gap: AD and SRAS intersect to the right of LRAS. Actual output (Qe) exceeds potential output (Yf). The economy is overheating.
Recessionary gap: AD and SRAS intersect to the left of LRAS. Actual output (Qe) is below potential output (Yf). Resources are underutilised and unemployment is high.
Demand-pull inflation (AD increases):
AD shifts to the right (caused by higher consumer confidence, increased government spending, etc.).
Both the price level and real GDP increase.
If the economy was at full employment, it moves into an inflationary gap.
Characterised by rising output and rising prices.
Cost-push inflation / Stagflation (SRAS decreases):
SRAS shifts to the left (caused by rising oil prices, higher wages imposed externally, supply chain disruptions, etc.).
The price level rises, but real GDP falls.
The economy moves into a recessionary gap with inflation, which is the definition of stagflation.
Characterised by falling output and rising prices. This is the more dangerous scenario because policy responses involve a trade-off: fixing inflation makes the recession worse, and fixing the recession makes inflation worse.
The economy has a built-in tendency to return to full-employment output over time, through wage adjustment:
Correcting a recessionary gap:
Unemployment is high, so workers have less bargaining power.
Over time, wages fall (or at least grow more slowly than they otherwise would).
Lower wages reduce firms' production costs.
SRAS shifts to the right.
The economy returns to LRAS at a lower price level.
Correcting an inflationary gap:
Unemployment is below the natural rate and labour markets are tight.
Workers demand and receive higher wages.
Higher wages increase firms' production costs.
SRAS shifts to the left.
The economy returns to LRAS at a higher price level.
In both cases, the long-run result is the same: output returns to Yf. Only the price level changes permanently.
Represented by a rightward shift of LRAS (and PPC).
Caused by increases in resources (more labour, more capital) or improvements in technology.
On the graph, the vertical LRAS line moves to the right, indicating a higher potential GDP.
If AD also increases to match, the economy can grow without deflation.
No new formulas in this section. Diagram skills are paramount:
You should be able to draw all three equilibrium scenarios from memory.
For each scenario, label: AD, SRAS, LRAS, the equilibrium price level (PLe), the equilibrium output (Qe), and full-employment output (Yf).
For demand-pull inflation: show AD shifting right with arrows indicating the new, higher price level and higher output.
For cost-push inflation: show SRAS shifting left with arrows indicating the new, higher price level and lower output.
For self-adjustment: show SRAS shifting in the corrective direction (right for recessionary gaps, left for inflationary gaps) with an arrow back toward LRAS.
The 2008 financial crisis is a clear example of a recessionary gap: AD collapsed as consumer spending and investment dried up, leaving output well below potential and unemployment above 10% in the US. The 1970s oil shocks are the classic example of cost-push inflation and stagflation: OPEC's supply restrictions raised production costs across the board, pushing prices up while output contracted.
Students frequently confuse demand-pull and cost-push inflation. The key: demand-pull comes from the demand side (AD shifts right), cost-push comes from the supply side (SRAS shifts left). If both output and prices rise, it is demand-pull. If prices rise but output falls, it is cost-push.
Students often forget that stagflation is still a recessionary gap, not a separate category. It is a recessionary gap caused specifically by a decrease in SRAS.
A common error is assuming the economy cannot produce beyond LRAS. It can, temporarily. An inflationary gap means the economy is running above sustainable capacity in the short run (workers are doing overtime, machines are running beyond normal schedules). This is not sustainable long-term.
Students sometimes describe long-run self-adjustment as AD shifting. It is not. The self-adjustment mechanism works through SRAS shifting as wages adjust. AD stays where it is unless policy changes it.
⚠️ Drawing and labelling the AD-AS model correctly is one of the most common free-response requirements. Practise until you can draw all three scenarios quickly and accurately.
⚠️ The difference between demand-pull and cost-push inflation is a near-guaranteed exam topic. Know which curve shifts, which direction, and what happens to both output and the price level.
⚠️ Long-run self-adjustment is a key concept for free-response questions that ask "what happens in the long run with no government intervention?" The answer is always: wages adjust, SRAS shifts, the economy returns to LRAS.
⚠️ When the exam asks about stagflation, it is testing whether you know this results from a decrease in SRAS, not an increase in AD.
⚠️ Economic growth questions test whether you can distinguish between a short-run increase in output (moving along SRAS) and a long-run increase in capacity (shifting LRAS).
True or False: In a recessionary gap, actual GDP is greater than potential GDP.
Demand-pull inflation is caused by a shift in which curve? In which direction?
True or False: Stagflation involves falling output and falling prices.
In the long-run self-adjustment of an inflationary gap, SRAS shifts ______ because wages ______.
Economic growth is shown by a rightward shift of which curve?
Answers: 1. False (actual GDP is less than potential GDP). 2. AD shifts to the right. 3. False (stagflation involves falling output and rising prices). 4. Left; rise (workers demand higher wages in a tight labour market). 5. LRAS.
Q: Draw and label an AD-AS model showing a recessionary gap. Identify the equilibrium price level, equilibrium output, and full-employment output.
A: The graph should show AD and SRAS intersecting to the left of the LRAS line. Label the intersection point's price level as PLe, the equilibrium output as Qe, and the LRAS position as Yf. The recessionary gap is the distance between Qe and Yf.
Q: Explain how the economy self-corrects from a recessionary gap in the long run.
A: In a recessionary gap, unemployment is above the natural rate. Over time, the surplus of labour causes wages to fall as workers compete for jobs. Lower wages reduce production costs for firms, which shifts SRAS to the right. This process continues until SRAS has shifted enough for the new AD-SRAS intersection to occur at the LRAS, restoring full-employment output at a lower price level.
Q: An oil price shock increases production costs across the economy. Using the AD-AS model, explain what happens to the price level, real GDP, and unemployment.
A: The increase in production costs shifts SRAS to the left. At the new equilibrium, the price level is higher and real GDP is lower. Because output has fallen, firms need fewer workers, so unemployment increases. This combination of rising prices and rising unemployment is stagflation.
Q: Distinguish between demand-pull inflation and cost-push inflation in terms of their effects on real GDP.
A: Demand-pull inflation results from an increase in AD, which raises both the price level and real GDP. Cost-push inflation results from a decrease in SRAS, which raises the price level while reducing real GDP. Both produce inflation, but they have opposite effects on output.
Q: Explain how economic growth is represented in the AD-AS model and name two causes.
A: Economic growth is shown by a rightward shift of the LRAS curve, indicating an increase in the economy's potential output. Two causes include an increase in the capital stock (more factories, equipment) and technological advancement (more efficient production methods).
The equilibrium model here is the framework you will use when studying fiscal policy (Topics 3.8–3.9) and monetary policy (Unit 4). Fiscal and monetary policies are tools for shifting AD to close gaps rather than waiting for long-run self-adjustment. The concept of economic growth connects back to the PPC from Unit 1 and forward to growth theory. Understanding whether the economy is in a recessionary or inflationary gap is also essential for interpreting the Phillips Curve (Unit 5).
AD-AS model, macroeconomic equilibrium, recessionary gap, negative output gap, inflationary gap, positive output gap, full employment equilibrium, demand-pull inflation, cost-push inflation, stagflation, long-run self-adjustment, wage adjustment, sticky wages, flexible wages, economic growth, potential GDP, LRAS shift, AP Macro Unit 3, national income and price determination