AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/3/3-7)
Unit 3 · Topic 3.7
3.7 Long-Run Self-Adjustment
If the government and central bank do nothing, an economy with an output gap eventually returns to full-employment output on its own. Nominal wages and other input prices adjust, which shifts SRAS until short-run equilibrium lands back on LRAS. Output and unemployment return to normal. After a demand shock, the price level ends up different from where it started.
Key terms
- long-run self-adjustment
- nominal wages
- flexible wages and prices
- natural rate of unemployment
- shift in SRAS
The mechanism
The key is that nominal wages (wages measured in dollars) are sticky only in the short run. Over time, as contracts end and workers and firms renegotiate, wages respond to conditions in the labor market. That changes production costs and shifts SRAS. AD stays where it is during the adjustment; it's SRAS that moves.
Closing a recessionary gap
Start with short-run equilibrium left of LRAS: output Y1 below YF, unemployment above the natural rate.
With many workers looking for jobs, nominal wages and other input prices eventually fall. Lower costs shift SRAS right (SRAS1 to SRAS2).
The new long-run equilibrium is where AD crosses SRAS2 on LRAS. Real output is back at YF, unemployment is back at the natural rate, and the price level is lower than it was during the recession.
Closing an inflationary gap
Start with short-run equilibrium right of LRAS: output Y1 above YF, unemployment below the natural rate.
Firms compete for scarce workers, and workers push for raises to keep up with rising prices. Nominal wages and other input prices rise, so SRAS shifts left (SRAS1 to SRAS2).
The new long-run equilibrium is back on LRAS at YF, with unemployment at the natural rate and a higher price level.
| Starting gap | Wages and input prices | SRAS shift | Long-run real GDP | Long-run price level (vs. the short run) | Long-run unemployment |
|---|---|---|---|---|---|
| Recessionary | Fall | Right | Back to YF | Lower | Natural rate |
| Inflationary | Rise | Left | Back to YF | Higher | Natural rate |
What the long run tells you
Compare where the economy started (before the shock) with where it ends up. After a demand shock, the long-run result is the same real output, YF, at a different price level. A lasting increase in AD only raises prices in the long run; a lasting decrease only lowers them.
Supply shocks self-correct too, but the price level ends somewhere different. Say an oil price spike shifts SRAS left and causes stagflation: a higher price level and output below YF. With unemployment above the natural rate, nominal wages eventually fall, and SRAS shifts back to the right. If AD hasn't changed, the economy returns to where it started: the original price level and YF. The long-run price level is lower than during the stagflation, but not lower than before the shock.
How long self-adjustment takes is a real debate. Some economists think wages adjust quickly enough that policy isn't needed. Others think wages fall slowly, especially in recessions, so a gap could last a long time without help from fiscal or monetary policy. The AP exam asks you to show the mechanism, not take a side.
A shift of LRAS itself is different: it means the economy's full-employment output has changed, which is economic growth or decline (5.6).
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Self-adjustment after a demand drop
An economy starts in long-run equilibrium at PL1 and YF. Investment spending falls, shifting AD left. Assuming no policy action, describe (a) the short-run outcome and (b) the long-run outcome, compared with where the economy started.
Show the solutionHide the solution
- Step 1: (a) AD shifts left to AD2. In the short run, the economy moves along SRAS1 to PL2 < PL1 and Y2 < YF. Unemployment rises above the natural rate.
- Step 2: (b) With high unemployment, nominal wages eventually fall. Lower costs shift SRAS right to SRAS2.
- Step 3: SRAS keeps shifting until AD2 and SRAS2 cross on LRAS. Real GDP returns to YF and unemployment to the natural rate.
- Step 4: Compared with the start, the price level (PL3) is lower than PL1, and lower than PL2 as well. Real output is the same as it was at the start.
Answer: (a) Lower price level, lower real GDP, higher unemployment. (b) In the long run, real GDP is back at YF, unemployment is at the natural rate, and the price level is lower than it started.
- Example 2
Which curve moves? (classic trap)
An economy has an inflationary gap. A student says it will self-correct because "AD will shift back to the left." What's wrong, and what actually happens?
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- Step 1: Nothing in the self-adjustment process changes C, I, G or Xn, so AD doesn't shift back on its own.
- Step 2: What changes is costs. With unemployment below the natural rate, nominal wages rise, which shifts SRAS left.
- Step 3: Equilibrium moves up along AD until it reaches LRAS. Output falls back to YF and the price level ends higher.
- Step 4: LRAS doesn't move either, because the economy's capacity hasn't changed.
Answer: SRAS, not AD, shifts left as nominal wages rise; output returns to YF at a higher price level.
Common mistakes
- Shifting AD during self-adjustment. Without policy, the adjustment comes through SRAS.
- Shifting SRAS the wrong way. A recessionary gap leads to lower wages and a rightward SRAS shift; an inflationary gap leads to higher wages and a leftward shift.
- Saying the price level returns to where it started. After a demand shock, the long-run price level is different from the original.
- Moving LRAS to meet the short-run equilibrium. LRAS stays at YF unless capacity changes.
On the exam
- Free-response questions often ask: "If no policy action is taken, what will happen to nominal wages in the long run? Explain." Name the direction of wages, the SRAS shift, and the result for output and the price level.
- Be clear about which comparison is asked: long run vs. short run, or long run vs. the original equilibrium.
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Check yourself
4 questions on 3.7 Long-Run Self-Adjustment. Pick an answer to see if you got it, and why.
An economy is in a recessionary gap, and the government takes no policy action. According to the AD–AS model, how does the economy return to full-employment output in the long run?
An economy is producing beyond full-employment output, and there is no government policy action. In the long run, which of the following will occur?
An economy starts in long-run equilibrium. A sharp rise in oil prices shifts SRAS to the left. If the government takes no policy action, which of the following is most likely in the long run?
After a negative AD shock, the economy is allowed to self-adjust. Compared with the original long-run equilibrium, the new long-run equilibrium has
0 of 4 answered