3.7 — Long-Run Self-Adjustment

From 3.5 — Equilibrium in Aggregate Supply and Demand, we know that an economy can be in three situations:

1. Full-employment
2. Recessionary gap
3. Inflationary gap

When there’s no government intervention or policy to help out with recessionary or inflationary gaps, we have long-run self-adjustment. Essentially, in the short run, an economy can be in many places: stagflation, recessionary gaps, and inflationary gaps. However, in the long run, it always ends up where it’s supposed to be, which is full employment.

Short-Run Supply Self-Adjustment

For example, in the below graph, there’s initially an inflationary gap where the economy is heating up and there’s a lot of money. But eventually, this also means that workers have higher wages and resources are more expensive, which corresponds with the leftward shift of the short-run aggregate supply curve. Eventually, this positions it back at the long-run aggregate supply. Essentially, the economy self-adjusts.

For the positive inflationary output gap, this usually recovers quite quickly. However, for a recessionary gap, the issue might be bigger. For example, if companies start to fire employees because of expenses, we have a lot of unused labour which eventually, due to the multiplier effect, leads to a deep and long recession.

Aggregate Demand Self-Adjustment

Even if the economy is at long-run equilibrium, we have full employment, which means there’s increased consumer spending and a rightward shift of AD, eventually leading to an inflationary gap. Then again, wages and resource prices will increase, which shifts the short-run aggregate supply curve to the left, and back to full employment.

Conversely, if we’re at full employment and there’s a decrease in consumer spending, we’ll have an AD shift leftward, resulting in a recessionary gap. Once again, theoretically, wages and resource prices will fall, and SRAS will shift right, bringing us back to full employment.

Shifts in the LRAS

Once again, if you have better resources or more resources, we’ll have an LRAS shift toward the right (similar to the PPC), signifying economic growth.