Long Run Self Adjustment

It's been some time since the U.S economy has seen inflation numbers as high as those this year. Housing prices have skyrocketed, and minimum wages have increased across many states. What should the U.S government do? Should it get involved and cool down inflation? You will be able to answer all these questions once you read our explanation on the long-run self-adjustment.

Macroeconomics Long Run Self-Adjustment Explanation

Macroeconomics long-run self-adjustment refers to the long-run equilibrium in the economy. We use the aggregate demand and aggregate supply (AD-AS) model to understand the long-run self-adjustment.

The AD-AS model consists of three important curves, aggregate demand, the short-run aggregate supply, and the long-run aggregate supply.

1. Aggregate demand refers to the total demand in an economy for goods and services.

2. The short-run aggregate supply in an economy refers to the total amount of goods and services produced during the short run.

3. The long-run supply refers to the potential output of an economy, given that it employs all its resources.

When these three curves intersect, they provide the long-run equilibrium in an economy. However, the economy is not always in its equilibrium. There are often shifts in either aggregate demand or short-run aggregate supply that might deviate from the equilibrium in the economy in the long run.

There are many reasons why the aggregate demand or short-run aggregate supply could shift. To learn all the reasons in detail, check our explanation of the equilibrium in the AD-AS model.

The long-run self-adjustment is when the economy goes back to its equilibrium point after receiving an economic shock.

Fig 1. - Long-run Self-Adjustment

1. Figure 1 shows the process of long-run self-adjustment. Assume a negative shock in the aggregate demand, which shifted the demand to the left (from AD₁to AD₂). The equilibrium in the AD-AS model changes (from E₁to E₂). At this point, there is a lower output produced(Y₂), and the prices in the economy drop(P₂).

2. In response to the decline in aggregate demand, which caused the prices to decrease, wages will eventually fall in the economy. Employers will start paying less as the decrease in price shrinks their profits, which causes the short-run aggregate supply to shift to the right (from SRAS₁to SRAS₂). That is because the cost of input (wages) decreases, allowing businesses to produce more.

3. This brings the economy back to full employment output(E₃), where the three curves intersect. However, the long-run equilibrium now is at lower prices.

The full-employment output would change only when there is a shift in the long-run aggregate supply. Note that there was no government intervention. It returned to its full-employment output by demand and supply forces such as flexible wages and prices. Self-adjustment is also known as self-correcting of the economy. At the heart of long-run self-adjustment is the idea that prices will adjust after a market shock.

Macroeconomics Long Run Self-Adjustment Example

Let's consider an example to understand the long-run self-adjustment process better. Assume that the economy initially is in equilibrium. Figure 2 shows the equilibrium. The aggregate demand, short-run aggregate supply, and long-run aggregate supply are equal at the equilibrium point.

Fig 2. - The economy in equilibrium

The economy's full-employment output (Y1) is at the price level (P1). After some period, the number of international entities depositing their funds in US banks increases. As more international entities continue to deposit funds in US banks, it increases thesupply of loanable funds. This decreases theinterest ratesin the economy, and borrowing money becomes cheaper for US citizens. As the interest rate decreases,investment spendingandconsumer spending增加。钱很便宜;为什么不买房子啊pen up a business? This causes the aggregate demand curve to shift to the right (from AD₁to AD₂), as seen in figure 3.

Fig 3. - Rightward shift in aggregate demand

After the aggregate demand has shifted, it moves the equilibrium point (from E₁to E₂). The change in equilibrium results in higher output(Y₂) and higher prices(P₂). As the price increases (from P₁to P₂), there is a movement along with the short-run aggregate supply (from E₁to E₂) as higher prices incentivize businesses to start producing more (from Y₁to Y₂). However, the increase in the price level causes a household's purchasing power to decrease.

Given time, this leads individuals to demand higher wages to cope with the price increase. As wages increase, it will cause the SRAS to shift (from SRAS₁to SRAS₂), as seen in figure 4.

Fig 4. - Long-run self-adjustment

Figure 4 points to the shift in SRAS (from SRAS₁to SRAS₂) due to an increase in wages. Businesses start producing less (from Y₂to Y₁) as the cost of labor increases. Additionally, they expect inflation to increase and spread across other production resources.

As the SRAS shifts to the left, there is a lower output produced (Y₁) in the economy, where the full employment level output occurs (LRAS). The long-run self-adjustment process resulted in higher prices (P₃).

Long-Run Self-Adjustment: Inflationary and Recessionary Gaps

Inflationary and recessionary gaps occur when there are shocks in the economy. A recessionary or inflationary gap will appear depending on whether it is a positive or negative aggregate demand shock.

But what do we mean by inflationary or recessionary gaps? These gaps are related to output gaps. An output gap is a difference between actual aggregate output and potential output. The output gap is expressed in percentage terms.

The formula to measure an output gap is as follows:

Inflationary gaps

Inflationary gaps are periods in the economy associated with an increase in the price level and the overall production in the economy. The inflationary gap occurs when a rightward shift in the aggregate demand curve happens.

Fig 5. - Inflationary Gap