# Macroeconomic equilibrium

> IB Economics SL · IB Economics SL Unit 3: Macroeconomics
> Source: https://www.owlsprep.com/study/ib-economics-sl-u3-macroeconomic-equilibrium/

This sub-topic explains how aggregate demand and aggregate supply interact to determine equilibrium output and price levels, covering short-run and long-run equilibrium and the nature of recessionary and inflationary output gaps.

**Prerequisites:** [Aggregate Demand (AD)](https://www.owlsprep.com/study/ib-economics-sl-u3-aggregate-demand/); [Short-run and Long-run Aggregate Supply (AS)](https://www.owlsprep.com/study/ib-economics-sl-u3-aggregate-supply/)

## Learning objectives

- Define short-run and long-run macroeconomic equilibrium
- Illustrate equilibrium outcomes using the AD-AS model
- Identify and describe recessionary and inflationary output gaps
- Explain how the economy adjusts between short-run and long-run equilibrium

## Short-Run Macroeconomic Equilibrium

**Short-run macroeconomic equilibrium** — Occurs when aggregate demand (AD) equals short-run aggregate supply (SRAS), jointly determining the equilibrium price level and equilibrium real output

*Example:* At this intersection, the total quantity of output demanded equals the total quantity supplied by firms, so there is no pressure for prices or output to change

If AD exceeds SRAS at the current price level, firms face excess demand, unsold inventories fall, and firms respond by increasing output and raising prices. If AD is less than SRAS, inventories build up, and firms cut output and prices. Adjustment stops when AD = SRAS.

**Worked example:** An economy has AD defined as $Y = 200 - 2P$ and SRAS defined as $Y = 50 + 3P$, where $Y$ is real output and $P$ is the price level. Calculate equilibrium output and price level.

1. 1. At short-run equilibrium, AD = SRAS, so set the two equations equal:
2. $$200 - 2P = 50 + 3P$$
3. 2. Rearrange to isolate terms for P:
4. $$200 - 50 = 3P + 2P \\ 150 = 5P$$
5. 3. Solve for equilibrium price level: $P = 30$
6. 4. Substitute $P = 30$ back into the AD equation to find equilibrium output:
7. $$Y = 200 - 2(30) = 140$$
8. 5. Verify with SRAS to confirm: $Y = 50 + 3(30) = 140$, so equilibrium is $P=30$, $Y=140$

## Long-Run Macroeconomic Equilibrium

**Long-run macroeconomic equilibrium** — Occurs when AD equals SRAS and also equals long-run aggregate supply (LRAS), so equilibrium output is equal to the economy's full-employment potential output ($Y_p$)

When the economy is at long-run equilibrium, there is no cyclical unemployment, all factors of production are fully employed. Any permanent change in AD only affects the long-run price level, not long-run real output, which stays at potential output.

**Worked example:** Illustrate and explain how an increase in AD leads to a new long-run equilibrium

1. 1. Start at initial long-run equilibrium: AD₁ intersects SRAS₁ and LRAS at potential output $Y_p$, price level $P_1$.
2. 2. An increase in consumer confidence shifts AD right to AD₂. In the short run, AD₂ intersects SRAS₁ at a new short-run equilibrium with output $Y_2 > Y_p$ and price $P_2$.
3. 3. In the long run, workers and firms adjust nominal wages to reflect the higher price level, increasing production costs for all firms. This shifts SRAS left to SRAS₂.
4. 4. The new long-run equilibrium occurs where SRAS₂ intersects AD₂ at LRAS, so output returns to $Y_p$, but the price level rises permanently to $P_3$.

> **tip**
>
> Always label all curves, axes, and equilibrium points clearly on AD-AS diagrams to earn full marks in IB exams.

## Output Gaps

**Output gap** — The difference between actual equilibrium real output and the economy's potential (full-employment) output. Gaps occur when the economy is in short-run equilibrium but not long-run equilibrium.

- **Recessionary (deflationary) gap:** Actual output < potential output. Cyclical unemployment is positive, and there is downward pressure on prices.
- **Inflationary (expansionary) gap:** Actual output > potential output. The economy is overheating, and there is strong upward (inflationary) pressure on prices.

**Worked example:** An economy has potential output of \$500 billion, and current short-run equilibrium output of \$470 billion. Identify the type of output gap and describe its characteristics.

1. 1. Calculate the output gap: Actual output - Potential output = 470 - 500 = -\$30 billion
2. 2. A negative output gap confirms this is a recessionary (deflationary) gap.
3. 3. On an AD-AS diagram, the intersection of AD and SRAS lies to the left of the vertical LRAS curve at Yp = 500.
4. 4. Key characteristics: positive cyclical unemployment, downward pressure on wage and price growth, spare capacity in the economy.

**Check your understanding**

Test your understanding:

1. If an economy's actual output is 5% above potential output, what type of gap exists?

   - Recessionary gap
   - Inflationary gap
   - Long-run equilibrium gap
   - Supply-side gap

   *Answer:* Inflationary gap

   *Why:* Correct: Output above potential output creates an inflationary gap, with upward pressure on prices. Recessionary gaps occur when output is below potential.

## Common pitfalls

- **Wrong:** Drawing long-run equilibrium with output different from potential output
  - Why it fails: By definition, long-run equilibrium requires output to be at full-employment potential, so any deviation means the economy is still adjusting
  - Correct: Always draw long-run equilibrium at the intersection of AD, SRAS and LRAS, at the vertical position of LRAS.
- **Wrong:** Describing the output gap as the vertical distance between AD and LRAS
  - Why it fails: Students confuse the gap between curves with the gap in output levels
  - Correct: The output gap is a horizontal difference: it is the difference between actual equilibrium output and potential output, measured along the real output axis.
- **Wrong:** Forgetting to shift SRAS when moving from short-run to long-run equilibrium after an AD change
  - Why it fails: Many students stop at the new short-run equilibrium and do not show the long-run adjustment of nominal wages and SRAS
  - Correct: Always include the SRAS shift after an AD change to show the economy returning to potential output in the long run.
- **Wrong:** Assuming all output gaps are caused by shifts in AD
  - Why it fails: Supply-side shocks (like an oil price increase) can also shift SRAS and create output gaps, often with conflicting output and inflation outcomes
  - Correct: Always check what curve shifted first before identifying the type and cause of an output gap.

## Cheatsheet

| Equilibrium/Gap Type | Curves Intersecting At | Output Level | Key Outcome |
| --- | --- | --- | --- |
| Short-run Equilibrium | AD, SRAS | Any level | Price adjusts to clear the market |
| Long-run Equilibrium | AD, SRAS, LRAS | Equal to $Y_p$ (potential) |  |
| Recessionary Gap | AD, SRAS (left of LRAS) | Actual < Potential | Downward price pressure, cyclical unemployment |
| Inflationary Gap | AD, SRAS (right of LRAS) | Actual > Potential | Upward (inflationary) pressure, overheating |

## What's next

Macroeconomic equilibrium is the core framework for analyzing all macroeconomic policy and outcomes in IB Economics. The output gaps you explored here are the primary justification for government and central bank intervention to stabilize the economy. Understanding how equilibrium adjusts to shocks also underpins analysis of inflation, unemployment, and economic growth. Next, you will explore how different policy types are used to close output gaps, reduce volatility, and achieve key macroeconomic objectives.

- [Supply-Side Policies](https://www.owlsprep.com/study/ib-economics-sl-u3-supply-side-policies/)
- [Unemployment and inflation](https://www.owlsprep.com/study/ib-economics-sl-u3-unemployment-and-inflation/)
- [Income distribution and equity](https://www.owlsprep.com/study/ib-economics-sl-u3-income-distribution-and-equity/)

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