AD–AS equilibrium, output gaps and long-run self-adjustment

Learning objectives

Draw a correctly labeled AD–AS graph showing short-run equilibrium output and price level, and add LRAS to show whether the economy is at, above or below full employment

Identify a recessionary (negative output) gap and an inflationary (positive output) gap on the graph and relate each to cyclical unemployment and inflation

Analyze the short-run effects of a shift in AD on real output, the price level and unemployment, distinguishing demand-pull inflation from a demand-driven recession

Analyze the short-run effects of a shift in SRAS, including a negative supply shock that causes stagflation (falling output with cost-push inflation)

Explain how the economy self-adjusts in the long run: nominal wages fall during a recessionary gap and rise during an inflationary gap, shifting SRAS until output returns to potential

Explain why long-run adjustment can be slow, particularly when wages are sticky downward, and why this creates a case for stabilization policy