Long-Run Self-Adjustment: Study Guide (Macroeconomics 3.7)

The idea: an economy off LRAS will not stay there

In Topic 3.6 a shock to aggregate demand (AD) or short-run aggregate supply (SRAS) moved the economy to a new short-run equilibrium. Often that equilibrium is not on the long-run aggregate supply (LRAS) curve. Real GDP is below or above full-employment output, Yf, and there is an output gap.

This topic asks: what happens next if the government does nothing?

The answer comes from the difference between the short run and the long run (Topic 3.4). In the short run, nominal wages and some other input prices are fixed by contracts. In the long run they are fully flexible. When contracts come up for renewal, wages respond to the state of the labour market:

• If unemployment is above the natural rate, there are more workers than jobs. Workers accept lower nominal wages, or smaller rises than before.
• If unemployment is below the natural rate, firms compete for scarce workers. Nominal wages rise.

A change in nominal wages changes firms’ costs at every level of output, so it shifts SRAS (Topic 3.3). SRAS keeps shifting until the gap has closed: real GDP is back at Yf and unemployment is back at its natural rate. This process is called long-run self-adjustment.

Three points to hold on to:

1. Self-adjustment shifts SRAS, not AD and not LRAS.
2. It happens in the absence of government policy. Nobody plans it; it is the result of wages and prices changing.
3. It ends at the point where AD crosses LRAS. Where AD is in the long run decides the long-run price level.

Closing a recessionary gap

A recessionary (negative) output gap means real GDP is below Yf. Step by step:

1. Shock. AD falls (for example, foreign buyers cut orders). Short-run equilibrium moves down and left along SRAS: the price level falls, real GDP falls below Yf, and unemployment rises above the natural rate.
2. Labour market. Cyclical unemployment means many people are looking for work. As contracts are renewed, nominal wages fall.
3. SRAS shifts right. Lower wages lower costs at every level of output.
4. Long-run equilibrium. The price level falls further and real GDP rises back to Yf, where the new SRAS, AD and LRAS all meet. Unemployment is back at the natural rate.

Compared with before the shock, the long-run result is a lower price level, the same real output and the same unemployment rate.

Background, not required: wages often fall more slowly than they rise, because workers resist pay cuts. This is one reason recessions can last a long time if nothing is done, and why governments use the stabilisation policies you meet next in Topic 3.8.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). The figures continue Topics 3.3 and 3.4. All data are fictional.

• Labour force: 25.0 million. Natural rate of unemployment: 5.0%.
• Full-employment output: Yf = VD 840 billion.
• From the Topic 3.3 table: every VD 40 billion of real output is 0.25 million jobs, which is 1 percentage point of unemployment.

Worked example 1: a recessionary gap closes by itself

Question. Valdoria starts in long-run equilibrium at a price level of 104. Then its main export market goes into recession, and AD falls by VD 80 billion at every price level (AD₁ to AD₂). The government takes no action. The table shows the schedules (VD billion).

Price level	92	96	100	104	108	112
AD₁	960	920	880	840	800	760
AD₂	880	840	800	760	720	680
SRAS₁	720	760	800	840	880	920

(a) Find the short-run equilibrium after the shock. Identify the gap and the unemployment rate. (b) A typical worker’s contract pays VD 26 an hour. Explain why firms hire fewer workers in the short run, using the real wage. (c) Find the long-run equilibrium price level and real GDP. By how much must SRAS shift? (d) Compare the long-run outcome with the outcome before the shock.

(a) AD₂ = SRAS₁ at a price level of 100, where both equal VD 800 billion. This is VD 840 − 800 = VD 40 billion below Yf: a recessionary gap of 40 ÷ 840 × 100 = 4.76% of Yf. Output is one VD 40 billion step below Yf, so unemployment is 5.0 + 1.0 = 6.0%. Cyclical unemployment is 1.0 percentage point: 0.01 × 25.0 million = 0.25 million people.

(b) Before the shock the real wage was 26 ÷ 1.04 = VD 25 an hour in base-year valdas. The price level has fallen to 100, but the contract still pays VD 26, so the real wage is now 26 ÷ 1.00 = VD 26. Each worker costs firms more in real terms while their products sell for less, so firms hire fewer workers and produce less.

(c) In the long run output must return to Yf = 840 on AD₂. From the table, AD₂ = 840 at a price level of 96. The new curve, SRAS₃, must pass through (840, 96). On SRAS₁, VD 840 billion was supplied at 104; on SRAS₃ it is supplied at 96. At a price level of 96, SRAS₁ gave 760, so SRAS must shift right by 840 − 760 = VD 80 billion at every price level. (Check at 104: SRAS₃ gives 920 = 840 + 80.) For this to happen, the nominal wage must fall to the level that restores the real wage of VD 25: 25 × 0.96 = VD 24 an hour, a fall of 7.69%.

(d) Real GDP is back at VD 840 billion and unemployment at 5.0%, the same as before the shock. The price level is 96, lower than the original 104 (a fall of 7.69%). The real wage is back at 24 ÷ 0.96 = VD 25. In the long run the AD shock has changed only the price level.

Check. The SRAS shift (VD 80 billion) is larger than the gap (VD 40 billion). That is not a mistake: as SRAS shifts right, the price level falls and the economy moves down AD₂, so the shift has to cover the whole horizontal distance between SRAS₁ and AD₂ at the new price level.

Closing an inflationary gap

An inflationary (positive) output gap means real GDP is above Yf. The steps mirror the recessionary case:

1. Shock. AD rises. The price level rises, real GDP rises above Yf, and unemployment falls below the natural rate.
2. Labour market. Firms struggle to find workers. Workers also see that prices have risen and their real wage has fallen. As contracts are renewed, nominal wages rise.
3. SRAS shifts left. Higher wages raise costs at every level of output.
4. Long-run equilibrium. The price level rises further and real GDP falls back to Yf. Unemployment returns to the natural rate.

Compared with before the shock: a higher price level, the same real output, the same unemployment rate.

Worked example 2: an inflationary gap closes by itself

Question. In a different year, Valdoria is again in long-run equilibrium at a price level of 104 with SRAS₁. A boom in foreign tourism raises AD by VD 40 billion at every price level (AD₁ to AD₃).

Price level	102	104	106	108	110
AD₃	900	880	860	840	820
SRAS₁	820	840	860	880	900

(a) Find the short-run equilibrium and the unemployment rate. (b) Explain why nominal wages rise. (c) Find the long-run equilibrium and the shift in SRAS. (d) Calculate the inflation rate between the start and the long run.

(a) AD₃ = SRAS₁ at a price level of 106 and real GDP of VD 860 billion: an inflationary gap of VD 20 billion. That is half of a VD 40 billion step, so unemployment is 5.0 − 0.5 = 4.5%, about 0.125 million people fewer unemployed than at the natural rate.

(b) Unemployment is below the natural rate, so workers are scarce and firms bid for them. Prices have risen by (106 − 104) ÷ 104 × 100 = 1.92%, so workers on old contracts have lost purchasing power and ask for higher pay when contracts are renewed.

(c) Long run: AD₃ = 840 at a price level of 108. The new curve, SRAS₄, passes through (840, 108). At 108, SRAS₁ gave 880, so SRAS shifts left by VD 40 billion (at 104, SRAS₄ gives 800). Real GDP is back at VD 840 billion and unemployment at 5.0%.

(d) Inflation from start to long run = (108 − 104) ÷ 104 × 100 = 3.85%. The boom has left Valdoria with a higher price level and no lasting gain in output or jobs.

Check. The price level rose in two stages: 104 → 106 in the short run (moving along SRAS₁), then 106 → 108 in the long run (SRAS shifting left). Output went the other way: up to 860, then back to 840.

Supply shocks and self-adjustment

A negative supply shock, such as a sudden jump in imported energy prices or a drought, shifts SRAS left. In the short run the price level rises while real GDP falls and unemployment rises: stagflation (Topic 3.6).

With no government policy, the high unemployment puts downward pressure on nominal wages. As wages fall, SRAS shifts back to the right. If the shock was temporary (for example, energy prices fall back), SRAS returns to its original position. The economy ends where it started: original price level, Yf, natural rate. The reason is that AD and LRAS have not moved, and the long-run equilibrium is always where AD crosses LRAS. (A shock that permanently destroys capacity is different: it shifts LRAS left, as described below.)

A positive supply shock (SRAS right) works in reverse: output above Yf and a lower price level in the short run; then wages and input prices rise, SRAS shifts back left, and the economy returns to its starting point.

Summary: short run and long run after each shock

Shock (no policy)	Short run	Self-adjustment	Long run compared with before the shock
AD decreases	PL ↓, real GDP ↓, unemployment ↑	Wages fall, SRAS shifts right	PL lower; real GDP = Yf; unemployment = natural rate
AD increases	PL ↑, real GDP ↑, unemployment ↓	Wages rise, SRAS shifts left	PL higher; real GDP = Yf; unemployment = natural rate
SRAS decreases (temporary)	PL ↑, real GDP ↓, unemployment ↑	Wages fall, SRAS shifts back right	PL, real GDP and unemployment back where they started
SRAS increases (temporary)	PL ↓, real GDP ↑, unemployment ↓	Wages rise, SRAS shifts back left	PL, real GDP and unemployment back where they started

Shifts of the LRAS curve: a change in full-employment output

Self-adjustment never moves LRAS. LRAS shifts only when the economy’s capacity changes (Topic 3.4): the quantity or quality of resources, or technology.

• A rightward shift of LRAS means full-employment output has increased. This is economic growth: the economy can now sustain a higher real GDP. The PPC shifts outward at the same time.
• A leftward shift means full-employment output has fallen, for example after a disaster destroys factories and roads.

Suppose a larger skilled labour force and better technology raise Valdoria’s Yf from VD 840 billion to VD 861 billion. Full-employment output has grown by (861 − 840) ÷ 840 × 100 = 2.5%. LRAS shifts right to 861. If real GDP stayed at 840, Valdoria would now have a recessionary gap of VD 21 billion, measured against the new Yf. Self-adjustment would then pull output towards 861, not 840.

So keep three different movements apart: an AD shock changes the long-run price level only; a temporary SRAS shock changes nothing in the long run; an LRAS shift changes the output the economy returns to. You will study the causes of growth in Topics 5.6 and 5.7.

Common misconceptions

• “Self-adjustment shifts AD back.” It shifts SRAS. AD stays where the shock left it unless policy or another shock moves it.
• “After a recession the price level returns to where it was.” After an AD fall, the long-run price level is lower than before. It returns to its starting value only after a temporary SRAS shock.
• “In a recessionary gap wages rise to help workers.” High unemployment pushes nominal wages down, and that is what shifts SRAS right.
• Shifting SRAS the wrong way for an inflationary gap. Higher wages raise costs: SRAS shifts left.
• “The economy ends where AD crosses SRAS₁.” That is the short run. The long-run equilibrium is where AD crosses LRAS.
• “Self-adjustment shifts LRAS to meet the economy.” LRAS moves only when resources or technology change.
• “The SRAS shift equals the output gap.” The shift is usually larger, because the price level changes while SRAS moves (Worked example 1, Check).
• “Self-adjustment is quick.” The model says it happens in the long run, which can be a slow and painful wait for the unemployed.

Where this leads

Waiting for wages to adjust can take a long time. In Topic 3.8, Fiscal Policy, the government uses spending and taxes to close gaps more quickly. If short-run shocks are not yet secure, go back to Topic 3.6.

Now try the practice questions, then use the revision notes and the checklist to consolidate.