3.7 Long-Run Self-Adjustment

Short-Run Gaps Trigger Adjustment

When real GDP differs from potential (full-employment) GDP, the economy has an output gap. A recessionary gap causes unemployment, and an inflationary gap causes overheating. In the long run, wages and prices are flexible, so the economy self-corrects back to full-employment output without government intervention.

How Self-Correction Works

In a recessionary gap, high unemployment pushes wages and input prices down, shifting SRAS rightward until output returns to potential GDP at a lower price level. In an inflationary gap, low unemployment pushes wages and prices up, shifting SRAS leftward until output falls back to potential GDP at a higher price level.

Long-Run Equilibrium

The long-run aggregate supply (LRAS) curve is a vertical line at potential/full-employment GDP, reflecting that in the long run, output depends only on resources and technology, not price level. Long-run equilibrium occurs where AD, SRAS, and LRAS all intersect at the same output level.

Key terms

LRAS curve

Vertical line at potential (full-employment) GDP; shows output depends on resources/technology, not price level.

Recessionary gap

Real GDP < potential GDP; leads to falling wages, which shift SRAS right until output returns to potential GDP.

Inflationary gap

Real GDP > potential GDP; leads to rising wages/prices, which shift SRAS left until output falls back to potential GDP.

Self-correction mechanism

The process by which flexible wages and prices automatically return the economy to potential GDP in the long run.

Long-run equilibrium

The point where AD, SRAS, and LRAS all intersect at potential GDP, with no remaining output gap.

Try an AP-style question

In a recessionary gap with no policy, the economy self-corrects as…

1. LRAS shifts left
2. wages rise and SRAS shifts left
3. wages fall and SRAS shifts right
4. AD shifts right on its own