Question

In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?

Short answer

At the level of GDP, equilibrium occurs when AD equals AS. Inadequate aggregate demand may explain why the equilibrium occurs at a GDP level below potential. Another factor could be a decline in aggregate supply.

Step-by-step solution

Concept introduction

At the level of production, equilibrium occurs when aggregate demand equals aggregate supply.

Explanation

The equilibrium output and price level are determined graphically when the AD curve intersects the AS curve.

There are primarily two reasons why the economy is unable to achieve equilibrium at maximum output.

Insufficient aggregate demand causes the AD curve to shift to the left, explaining why the economy is far from its potential GDP.

A decline in supply could also be a factor in the economy failing to realise its full potential.

Both of the aforementioned factors contribute to slower economic development and higher unemployment rates.