How Does the Neoclassical Model Restore Equilibrium?
Aggregate demand and supply
What you will learn
- In this model, wage and cost adjustment brings output back to potential after a demand shock.
- Explain wage and cost adjustment after demand shocks
Essential definitions
- Short-run equilibrium
- The intersection of AD and SRAS, where planned spending equals short-run production.
- Long-run equilibrium
- In the neoclassical model, the intersection of AD and SRAS at potential output on LRAS.
Begin at potential output
Equilibrium is where planned spending equals production. In an AD–AS diagram, put real GDP horizontally and the price level vertically. AD slopes down, SRAS slopes up and LRAS is vertical at potential output, Yp. Initially AD1 and SRAS1 meet on LRAS. That is both a short-run and long-run equilibrium.
Now suppose confidence rises and AD shifts right to AD2. Wages are initially slow to change, so firms raise production. The new short-run intersection lies to the right of Yp and at a higher price level. Output can exceed potential temporarily through overtime and unusually intensive resource use; LRAS has not moved.
Follow the return after demand rises
Tight labour markets make recruitment harder. Workers seek higher pay, including compensation for expected price rises. As wages and other costs increase, SRAS shifts left. Output returns to Yp where the new SRAS meets AD2. The final price level is higher than initially, but potential output is unchanged.
For the first change, use E1 for the initial intersection and E2 for the new short-run intersection. Identify the later intersection as the long-run position rather than reusing the same label. Keep each change separate: AD shifts because spending changes, SRAS shifts because costs adjust, and LRAS stays put unless capacity changes.
Reverse the chain after demand falls
A fall in spending shifts AD left, lowering output and prices. Unemployment then puts downward pressure on wages in the model. Lower costs shift SRAS right until output returns to Yp at a lower price level. Moving AD back would describe a recovery in spending, not this cost-adjustment mechanism.
Contracts, resistance to wage cuts and weak confidence can delay the process. Falling prices can also make debt harder to repay, discouraging spending and investment. Explain why self-correction works under flexible prices before judging whether waiting is acceptable. The next lesson examines why Keynesian analysis allows unemployment equilibrium to persist.
Hypothetical positive gap
- Initial potential output is 1,000 billion and short-run output after a demand rise is 1,040 billion.
- Output gap = (1,040 − 1,000) ÷ 1,000 × 100 = 4%.
If capacity is unchanged, long-run self-correction returns output to 1,000 billion, not 1,040 billion.
Output gaps and classical adjustment
AD: P = 150 − 0.8Y. SRAS: P = 20 + 0.8Y. E2: Y=81.25, P=85. Short-run gap=-18.75%. After input costs adjust, the long-run position has Y=100 and P=70.
AD and SRAS can intersect away from potential in the short run. Below potential, unemployment can reduce wage growth and unit costs; SRAS moves down until output returns to potential. Above potential, input-cost pressure shifts SRAS up.
How to draw it and model assumptions
- Mark Yp with vertical LRAS.
- Mark initial E1 at potential, then short-run E2 left or right of Yp after the demand shock.
- Shift SRAS to the long-run position on LRAS; retain E2 so the temporary output gap stays visible.
Adjustment assumes flexible wages and prices over time, unchanged AD and unchanged capacity. It is not automatic or rapid under Keynesian assumptions.
Aggregate demand: expansion and contraction
AD: P = 200 − 0.8Y. SRAS: P = 20 + 0.8Y. E2: Y=112.5, P=110.
Higher autonomous spending raises AD. With upward-sloping SRAS, firms expand output as the price level rises relative to sticky input costs. A fall in AD reverses this short-run result.
How to draw it and model assumptions
- Price level (index) vertically and real GDP (index) horizontally.
- Label AD₁, AD₂ and SRAS.
- Project E1 and E2 to both axes and show the AD shift with an arrow.
Hypothetical linear AD and SRAS; input prices and productive capacity fixed in the short run. A shift is a change in spending at each price level.
Apply and evaluate
- Flexible wages and prices support self-correction, but institutional and behavioural rigidities can delay it.
- The social costs of waiting include lost income, skill erosion and reduced investment.
Common misconceptions
- The long-run equilibrium must lie on LRAS in this model.
- A short-run positive output gap does not require LRAS to slope upward.
Knowledge check
What shifts during neoclassical recovery from a negative demand shock without demand policy?
Real-world application
Energy costs and aggregate supply
16 November 2022: ONS reported that gas and electricity prices made the largest upward contribution to the change in UK annual consumer-price inflation between September and October 2022.
Model application: dearer energy can raise firms’ unit costs, shifting SRAS left. It also reduces households’ purchasing power, which can weaken demand. The observation alone does not identify the size of either shift or prove all inflation had one cause.
ONS, Consumer price inflation, UK: October 2022 ↗Historical evidence checked 9 October 2026. The model interpretation is an original teaching application.
What to remember
In this model, wage and cost adjustment brings output back to potential after a demand shock. The process can be slow and costly, so the model's mechanism needs to be evaluated.
Completion is your own reflection on learning, not a test score. Syllabus references: 3.2.12, 3.2.14, 3.2.15, 3.2.17.
Lessons in this section
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