Topic 3.7 Notes – Long-Run Self-Adjustment

Long-Run Equilibrium in the AD-AS Model

Here’s what long-run equilibrium looks like on the AD-AS graph:

Long-run equilibrium in the AD-AS model

At this point, the AD curve, SRAS curve, and the vertical LRAS curve all intersect at a single equilibrium.

• Real GDP equals full-employment output (the level shown by the vertical LRAS line, labeled Y₁ here)
• Unemployment equals the natural rate of unemployment (NRU)
  • Only frictional + structural
  • No cyclical unemployment
• The price level matches what workers and firms expected

Quick grounding:

• AD shows total spending in the economy.
• SRAS reflects production given current nominal wages and input prices.
• LRAS is vertical at full-employment output because in the long run, output depends on labor, capital, technology, and institutions, not the price level.

The key idea is simple. If a shock pushes the economy away from this point, flexible wages and input prices shift SRAS until output returns to full-employment output.

Recessionary and Inflationary Gaps

When AD or SRAS shifts, the economy leaves long-run equilibrium.

Recessionary Gap

When AD shifts left, the short-run equilibrium moves to the left of the vertical LRAS line at potential GDP.

A recessionary gap exists when:

• Real GDP is below $Y_f$
• Unemployment is above the NRU
• AD and SRAS intersect left of LRAS

Common cause:

• Decrease in AD (collapse in consumer confidence, stock market crash, financial crisis like 2008 or the Great Depression)

Short-run results:

• Output ↓
• Unemployment ↑
• Price level often ↓ (if AD fell)

The economy is producing inside its production possibilities frontier.

Inflationary Gap

Here, AD shifts right, pushing short-run equilibrium to the right of the vertical LRAS line. Output temporarily rises above potential.

Inflationary gap in the AD-AS model

An inflationary gap exists when:

• Real GDP is above $Y_f$
• Unemployment is below the NRU
• Labor shortages occur

Common cause:

• Increase in AD (stimulus spending, rapid credit expansion, wartime spending, late 1960s demand surge)

Short-run results:

• Output ↑
• Unemployment ↓
• Price level ↑

The economy is temporarily producing beyond sustainable capacity.

Self-Adjustment from a Recessionary Gap

This is where the model becomes dynamic.

1. High unemployment means excess labor supply.
2. Workers accept lower nominal wages.
3. Firms’ production costs fall.
4. SRAS shifts right.
5. Output increases back to $Y_f$.
6. Unemployment returns to the natural rate.

Long-run outcome:

• Real GDP restored to full employment
• Lower price level than before

After the 2008 recession, wage growth stayed weak for years. That slow wage adjustment helped shift SRAS right over time. The same mechanism operated during the recovery from the Great Depression, though policy also played a major role there.

On an FRQ, always say wages fall → SRAS shifts right → output returns to $Y_f$.

Self-Adjustment from an Inflationary Gap

Now reverse the pressure.

1. Very low unemployment creates labor shortages.
2. Workers demand higher nominal wages.
3. Firms face higher costs.
4. SRAS shifts left.
5. Output falls back to $Y_f$.
6. Unemployment rises back to NRU.

Long-run outcome:

• Real GDP returns to full employment
• Higher price level

This is why inflation often follows periods of overheating. In the late 1960s, strong aggregate demand pushed unemployment very low, wages rose, and inflation accelerated as SRAS shifted left.

Inflation can be the natural byproduct of closing an inflationary gap.

Permanent Shocks and LRAS Shifts

Self-adjustment assumes productive capacity stays the same. If the economy’s resources change, LRAS shifts.

LRAS shifts right

Causes:

• More labor
• More capital
• Technological improvement
• Better education and human capital
• Institutional improvements

Result:

• Higher $Y_f$
• Long-run economic growth
• Expansion of the production possibilities frontier

LRAS shifts left

Causes:

• War
• Major natural disaster
• Permanent productivity decline

Result:

• Lower $Y_f$
• Permanently smaller economy
• Higher price level

Only LRAS shifts change long-run output. AD and SRAS shocks change output temporarily.