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Macroeconomics: equilibrium in the AD/AS model

Real output and price level in the AD/AS model:
  • The short run equilibrium in the AD/AS model, is when the  intersection between the short run aggregate supply curve and the aggregate demand curve determines the level of output and price level.
       
  • This short equilibrium output can be compared to the full-employment (i.e long run equilibrium) output by adding the long run aggregate supply curve in the graph. 
    • If the difference between the short run equilibrium output and full employment output is negative than we have a recessionary gap. This could be caused by a decrease in households' consumption, a fall in private investments, or a decrease in government spending.
    • If the difference is positive, we have an inflationary gap, where the short run equilibrium output is bigger than its full employment output. This can be caused by an increase in households expenditures, expansionary fiscal policy, etc...
    • If the gap is zero, this means that the short run equilibrium output occurs at the full employment level of output. This means that this nation is achieving its macroeconomics objectives of stable prices (i.e stable inflation rate), and full employment. Thus, in the long run, its price level and output will not change.
Short run to long run AD/AS model:
  • In the long run a nation will always produce at its full employment level of output, regardless of its AD curve.
  • In the long run, wages and prices are perfectly flexible. Following a decrease in the aggregate demand, in the long run:
    • The SRAS shifts to the right, since firms are layoff workers. This increase in the size of the unemployed in the labor force causes the wage rate to fall.  
    • Output return to full employment because the lower prices (thanks to lower wages) increase the quantity of national output demanded over time.
    • The workers' nominal wages are lower, however the real wages (represented by real income, i.e GDP) are the same as they used to be before the fall in AD.
  • In this example, the movement in the SRAS relies on the fall in wages. However, this might take a long time. It might be quicker to "push" the AD to the right via fiscal expansionary policies.
  • Following an increase in the AD in the long run:
    • The SRAS will shift to the left as unemployment rate falls below the NRU, increasing the scarcity of labor, driving up the wage rate.
    • Output will return to the full employment level since higher prices caused by the higher wages will reduce the quantity of national output demanded over time.
    • workers' nominal wages are higher, but their real wages are the same as they were before the increase in AD.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 135-142.
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