AD-AS Equilibrium and Output Gap

Equilibrium in the AD-AS Model
The AD-AS model allows one to analyze how the interaction of aggregate demand and aggregate supply determines the price level and the level of production in the economy. Equilibrium and deviations from it have direct consequences for inflation, unemployment, and financial markets.

Short-Run Equilibrium
Short-run equilibrium is achieved at the intersection point of the AD and SRAS curves. At this point, the amount of output that firms are willing to produce equals the amount of output for which there is demand. The price level balances demand and supply. Short-run equilibrium may differ from long-run equilibrium, in which actual GDP equals potential GDP.

If short-run equilibrium lies to the left of LRAS, the economy produces less than potential—a recessionary gap. If it lies to the right—the economy is overheated, creating an inflationary gap.

Transition to Long-Run Equilibrium
The economy tends to return to long-run equilibrium through the mechanism of wage and price adjustment. In the case of a recessionary gap, high unemployment puts downward pressure on wages, shifting SRAS downward, increasing output and reducing prices. In an inflationary gap, low unemployment puts upward pressure on wage growth, SRAS shifts upward, output falls, and prices rise.

The speed of this adjustment depends on the flexibility of prices and wages. In economies with rigid labor and product markets, the adjustment can take years. This provides justification for stabilization policy, which can accelerate the return to equilibrium.

Output Gap and Its Measurement
The output gap is the difference between actual and potential GDP, usually expressed as a percentage of potential GDP: $ \text{Output gap} = \frac{Y - Y^}{Y^} \times 100%, $ where $Y$ is actual GDP, $Y^*$ is potential GDP.

A positive output gap ($Y > Y^$) indicates economic overheating. Resources are used above a sustainable level, creating inflationary pressure. A negative output gap ($Y < Y^$) indicates a recessionary situation—high unemployment, slack in production, downward pressure on prices.

Assessing potential GDP and the output gap is subject to significant uncertainty. Various methods are used: statistical filters (Hodrick-Prescott filter, Kalman filter), production functions, DSGE models. Different methods yield different estimates, and revisions may be significant.

Inflationary and Recessionary Gaps
An inflationary gap arises when aggregate demand exceeds potential output. The economy is in an overheated state: unemployment is below the natural rate, production capacity is utilized above optimum, and inflation accelerates. The central bank typically responds with a tightening policy.

A recessionary gap arises when aggregate demand is insufficient to ensure full employment. The economy is underutilizing its potential: unemployment is above the natural rate, capacity is underused, and inflation slows. This provides rationale for a stimulative policy.

Application for Investors
The output gap is a key indicator for forecasting monetary policy and inflation. A positive output gap increases the probability of policy tightening, which is negative for bonds and growth stocks. A negative output gap indicates the possibility of policy easing, which is positive for risk assets.

The dynamics of the output gap help determine the phase of the economic cycle. Narrowing of the negative gap indicates recovery. The transition from negative to positive gap signals the mid/late cycle with the risk of overheating.

Uncertainty in output gap estimates creates a risk of policy errors. If potential GDP is overestimated, policy may remain too accommodative for too long, allowing overheating. If underestimated—policy may be excessively tight, restraining growth.

Differences in output gap between countries create opportunities for relative rates. Countries with a negative gap may have looser policy than countries with a positive gap, affecting relative attractiveness of currencies and bonds.