Long-Run
Self-Adjustment

Explore how the economy naturally corrects itself over time through shifts in short-run aggregate supply, returning real GDP to its full-employment level.

AP Macroeconomics

What Is Long-Run Equilibrium?

In macroeconomics, long-run equilibrium occurs when three curves intersect at the same point: Aggregate Demand (AD), Short-Run Aggregate Supply (SRAS), and Long-Run Aggregate Supply (LRAS).

AD

Total spending at each price level: \( C + I + G + (X - M) \)

SRAS

Output firms supply in the short run, when input prices are sticky

LRAS

Full-employment output \( Y_f \): vertical line at potential GDP

The AD-AS Model at Equilibrium

Why the Economy Deviates

Demand shocks (changes in \( C \), \( I \), \( G \), or \( X - M \)) or supply shocks shift AD or SRAS, pushing the economy away from \( Y_f \). This creates either:

Recessionary Gap

Actual GDP < Potential GDP. High unemployment, downward pressure on wages and prices.

Inflationary Gap

Actual GDP > Potential GDP. Low unemployment, upward pressure on wages and prices.

The Self-Adjustment Mechanism

1

A shock occurs: AD shifts right (boom) or left (recession), moving the economy away from \( Y_f \).

2

Wages respond: In a boom, labor scarcity pushes wages up. In a recession, high unemployment pushes wages down.

3

SRAS shifts: Rising input costs shift SRAS left; falling input costs shift SRAS right.

4

New long-run equilibrium: Real GDP returns to \( Y_f \) at a new price level.

Closing a Recessionary Gap

Closing an Inflationary Gap

Short Run vs Long Run

	Short Run	Long Run
Wages & Input Prices	Sticky (fixed by contracts)	Flexible (adjust to conditions)
GDP vs \( Y_f \)	Can be above or below \( Y_f \)	Always returns to \( Y_f \)
Unemployment	Can differ from natural rate	Returns to natural rate
Price Level	Determined by AD ∩ SRAS	Adjusts to new equilibrium
Curve that Shifts	AD or SRAS (from shocks)	SRAS (from wage adjustment)

The Classical Perspective

Classical economists argue the economy is self-correcting and government intervention is unnecessary. Their logic rests on flexible wages and prices:

Flexible Markets

Wages and prices adjust freely to balance supply and demand in labor and goods markets.

No Intervention

Government fiscal or monetary policy is unnecessary because the economy naturally returns to \( Y_f \).

Speed of Adjustment

The main debate: classicals say "relatively fast," Keynesians say "painfully slow."

How to Apply Self-Adjustment

1

Identify the shock: Did AD shift? Did SRAS shift? In which direction?

2

Find the short-run equilibrium: Where do the new AD and original SRAS intersect? Is actual GDP above or below \( Y_f \)?

3

Determine the gap type: GDP > \( Y_f \) = inflationary gap. GDP < \( Y_f \) = recessionary gap.

4

Predict wage adjustment: Inflationary gap → wages rise → SRAS shifts left. Recessionary gap → wages fall → SRAS shifts right.

5

Find the new long-run equilibrium: SRAS shifts until it intersects AD at \( Y_f \) on the LRAS line. Note the new price level.

Example 1: Demand Shock (Recession)

Scenario: Consumer confidence falls sharply, causing aggregate demand to decrease. The economy was initially at long-run equilibrium.

1

AD shifts left (from AD₁ to AD₂): consumers spend less at every price level.

2

Short-run result: Real GDP falls below \( Y_f \), price level drops, unemployment rises above the natural rate.

3

Gap type: Recessionary gap (actual GDP < \( Y_f \)).

4

Long-run adjustment: High unemployment → wages fall → production costs decrease → SRAS shifts right.

5

New equilibrium: GDP returns to \( Y_f \) at a lower price level than the original equilibrium.

Example 2: Demand Shock (Boom)

Scenario: The government dramatically increases spending on infrastructure while the economy is already at \( Y_f \).

1

AD shifts right (from AD₁ to AD₂): government spending (\( G \)) increases total demand.

2

Short-run result: Real GDP exceeds \( Y_f \), price level rises, unemployment falls below the natural rate.

3

Gap type: Inflationary gap (actual GDP > \( Y_f \)).

4

Long-run adjustment: Low unemployment → workers demand higher wages → costs rise → SRAS shifts left.

5

New equilibrium: GDP returns to \( Y_f \) at a higher price level than the original equilibrium.

Example 3: Supply Shock (Stagflation)

Scenario: An oil embargo sharply increases energy costs, causing SRAS to shift left. The economy begins at \( Y_f \).

Short-Run Effect

SRAS shifts left → GDP falls below \( Y_f \), price level rises. This is stagflation: simultaneous recession and inflation.

Long-Run Self-Adjustment

If the shock is temporary, as the oil supply normalizes, SRAS shifts back right to restore \( Y_f \). If permanent, the economy adjusts at a higher price level.

Output and Price Level Effects

Scenario	Short Run	Long Run
AD increases	GDP ↑, PL ↑	GDP = \( Y_f \), PL ↑↑
AD decreases	GDP ↓, PL ↓	GDP = \( Y_f \), PL ↓↓
SRAS decreases	GDP ↓, PL ↑	GDP = \( Y_f \), PL returns*
SRAS increases	GDP ↑, PL ↓	GDP = \( Y_f \), PL returns*

Common Mistakes to Avoid

✕ Shifting the Wrong Curve

In long-run self-adjustment, only SRAS shifts. AD does not shift during self-correction, and LRAS never shifts from wage changes alone.

✕ Wrong Direction of Shift

Recessionary gap → wages fall → SRAS shifts right. Inflationary gap → wages rise → SRAS shifts left. Don't reverse them.

✕ Forgetting the Price Level Change

Real GDP returns to \( Y_f \), but the price level changes. After an AD increase, the final PL is higher than the original.

Question 1 of 5

An economy is in a recessionary gap. According to the long-run self-adjustment mechanism, which of the following will occur?

In a recessionary gap, high unemployment puts downward pressure on wages. Lower wages reduce production costs, causing SRAS to shift right until GDP returns to \( Y_f \). Government action (choice A) is fiscal policy, not self-adjustment.

Question 2 of 5

If aggregate demand increases while the economy is at full employment, which of the following describes the long-run result after self-adjustment?

After an AD increase creates an inflationary gap, wages eventually rise, shifting SRAS left. GDP returns to \( Y_f \), but the price level ends up higher than the original level. The economy cannot sustain output beyond potential GDP in the long run.

Question 3 of 5

During self-adjustment from an inflationary gap, what causes SRAS to shift left?

When unemployment is below the natural rate, workers have bargaining power and demand higher wages. These higher input costs cause firms to reduce output at every price level, shifting SRAS left. Choices B and C describe policy actions, not self-adjustment.

Question 4 of 5

An economy is currently producing beyond its full-employment output. If no government policy is enacted, which of the following sequences correctly describes the long-run self-adjustment?

When the economy is above \( Y_f \) (inflationary gap), unemployment is low, so wages rise. Higher wages shift SRAS left, pushing the price level up and GDP back to \( Y_f \). Choice B describes the recessionary gap correction.

Question 5 of 5

A Keynesian economist would most likely criticize the long-run self-adjustment model by arguing that:

Keynesians accept that self-adjustment can happen, but argue it takes too long. Wages are especially sticky downward: workers and unions resist pay cuts, so recessionary gaps persist, causing prolonged unemployment and economic pain. This is why Keynesians advocate active fiscal and monetary policy.

Long-RunSelf-Adjustment

What Is Long-Run Equilibrium?

The AD-AS Model at Equilibrium

Why the Economy Deviates

The Self-Adjustment Mechanism

Closing a Recessionary Gap

Closing an Inflationary Gap

Short Run vs Long Run

The Classical Perspective

How to Apply Self-Adjustment

Example 1: Demand Shock (Recession)

Example 2: Demand Shock (Boom)

Example 3: Supply Shock (Stagflation)

Output and Price Level Effects

Common Mistakes to Avoid

Question 1 of 5

Question 2 of 5

Question 3 of 5

Question 4 of 5

Question 5 of 5

Long-Run
Self-Adjustment