Lesson Summary

The economy of Petmeckistan has been thrown into a recession due to widespread pessimism by households and firms. Should the government leap into action and try to fix it?
Some economists think so, believing that policymakers should take an active approach to stabilize an economy. But other economists believe that intervention isn’t necessary most of the time. Rather, they believe that things will sort themselves out without immediate action needed. In this case, policy interventions might further stabilize an economy, so should only be used in extreme circumstances.
This second, “hands-off” approach assumes that there is a long-run self-adjustment mechanism. The long-run self-adjustment mechanism is one process that can bring the economy back to “normal” after a shock. The idea behind this assumption is that an economy will self-correct; shocks matter in the short run, but not the long run. At its core, the self-correction mechanism is about price adjustment. When a shock occurs, prices will adjust and bring the economy back to a long-run equilibrium.

Key terms

Key termDefinition
long-run self-adjustmentthe process through which an economy will return to full employment output even without government intervention
economic growthan increase in an economy’s ability to produce goods and services; in the AD-AS model economic growth is represented by an increase in the LRAS.

Key Takeaways

How short-run shocks to aggregate demand correct in the long run

Shocks are unanticipated changes in economic conditions. Demand shocks are unanticipated changes that impact the Aggregate Demand (AD) curve. The basic idea of the self-correction mechanism is that shocks only really matter in the short run. If AD changes, then output and unemployment will change in the short run, but not in the long run. Output gaps due to a change in AD exist in the short run only because prices haven’t had a chance to fully adjust to that change yet. Once those prices have fully adjusted in the long run, the output gap will close.
Let’s walk through how a shock to AD in the short run can be corrected in the long run.
First, the shock:
Everyone in Hamsterville woke up one morning filled with optimism and confidence that incomes were going to increase, and that this increase will be permanent. ¡Viva Hamsterville! This optimism triggers an increase in consumer spending, causing a positive shock to AD. An increase in consumer spending will cause the AD curve to increase. As a result, output increases and unemployment decreases. Unfortunately, this positive AD shock also means that inflation increases. An increase in AD leads to an increase in real GDP and the price level.
How is shock corrected in the long run?
Inflation has made everyone’s real wages decrease. Boo! As a result, workers demand higher wages. This drives up the cost of labor. Rising labor costs causes SRAS to decrease. This happens because expectations of further inflation and higher resource costs lead firms to produce less and charge higher prices. Output decreases and the price level increases. Output keeps falling and price level keeps rising until real GDP returns to full employment output. As long as output is higher than full employment output, an unemployment rate that is higher than the natural rate will put upward pressure on wages and prices. The long-run outcome is that real GDP returns to the full employment level of output and the unemployment rate is equal to the natural rate. The price level, however, is now permanently higher.
We can better understand how the self-adjustment mechanism plays out by thinking about all of the coffee shops in Hamsterville. An increase in AD means coffee shops can sell more goods at higher prices. Coffee shops raise the price of a latte 10%10\% from to $5.50\$5.50.
At the same time, the baristas making those lattes see the prices all around them rising too. But their paycheck hasn’t changed. They are able to buy less stuff, so effectively their real wages have decreased. At the same time, they see help wanted ads all over the place from other firms desperate to hire workers because the unemployment rate is so low. The baristas all quit and find better-paying jobs.
Now the coffee shop owners have to hire more workers. In order to attract workers, they have to raise wages too. Eventually, every firm in Hamsterville is paying higher wages. At the national level, increases in wages and other input costs mean the SRAS will decrease (because SRAS decreases when input prices increase or are expected to increase). Output returns to full employment output, and unemployment returns to the natural rate of unemployment. However, the economy also ends up with a higher price level. In the long-run, the price level increased, but output didn’t and the unemployment rate is once again equal to the natural rate of unemployment.

How short-run shocks to SRAS correct in the long run

Supply shocks are a little different from demand shocks. In this case, the long run impact will depend on whether those shocks are temporary or permanent. For example, suppose an increase in the price of oil leads to a negative supply shock (because an increase in input prices will cause SRAS to decrease). Here’s what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up. The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages). SRAS increases once wages have adjusted, because a decrease in the price of a input to production will lead to an increase in SRAS. Output returns to the full employment output.
On the other hand, if a shock is permanent, there is an entirely different impact. Suppose that there is a permanent negative supply shock that makes the entire economy less productive, such as stricter regulations on production. Here’s what will happen: The capacity of the economy has decreased, so LRAS shifts to the left. Because such regulations make the cost of production higher, SRAS will also decrease until output has returned to the full employment output. In this case, output is permanently lower and the price level permanently higher.

Only increases in LRAS will lead to more output in the long-run

It’s not all about shocks! How much you can produce sustainably has more to do with your resources than with shocks. The self-adjustment mechanism occurs because the amount of output that a country can sustainably produce ultimately depends on its stock of resources, not on AD or SRAS.
Recall that the LRAS is vertical at the full employment output. This is the amount of output associated with any point on the PPC. Unless the amount of resources a country changes, that maximum sustainable output won’t change either.
For example, if a country has 100100 workers working 8-hour shifts every day, that’s 800800 hours worth of labor being used to produce. You might be able to temporarily make everyone work overtime and squeeze out 1,0001{,}000 hours worth of effort, but that isn’t sustainable. Unless the number of workers increases, you are stuck with however much output 800800 hours worth of labor will produce. If you did get more workers, then the PPC would shift out and the LRAS curve would also shift out. That shift in LRAS represents economic growth. Temporarily pushing output past that amount doesn’t count as economic growth.

Key Graphs

Long-run self-adjustment to positive AD shock

Figure 1: Long run self-adjustment to a positive aggregate demand shock
This economy is initially in long-run equilibrium. Its current output (Y1Y_1) is the same as its full-employment output (YfY_f).
Then, one of the components of AD increases, as shown by shift (1). As a result, output and the price level increase.
An increase in the price level will drive up input prices and expectations about inflation, which leads to the decrease in SRAS shown by shift (2). In the long run, the price level has increased, but the new output (Y3Y_3) is once again equal to the full employment output (YfY_f).
Yes, you are seeing that right, and yes, that is a lot of labeling!
The good news is you are likely to have all of these steps broken down for you by a test writer on an exam. They usually won’t throw the whole graph at you in a single question with a 16-point checklist to follow to make sure you are getting everything. Your objective is to break each phase of this self-correction mechanism down and correctly labeled based on that phase. Those phases are Some initial condition of the economy. An economy could be in long-run equilibrium, a recession, or an expansion. Start out by creating an AD-AS model based on that condition. Something happens to change that condition. Add whatever will happen as a consequence of that change to your AD-AS model.
If you break the mechanism into steps, and focus on correctly showing each of those steps correctly, creating the model is a lot more manageable. See the article <How to break down a question on graphing the self-correction mechanism> for a demonstration of this.

Long-run self-adjustment to negative AD shock

Figure 2: Long-run self-adjustment to a negative aggregate demand shock
This economy is initially in long-run equilibrium. Its current output (Y1Y_1) is the same as its full-employment output (YfY_f). Then, one of the components of AD decreases, as shown by shift (1). As a result, output and the price level decrease. In the long run, a decrease in the price level will drive down input prices and expectations about inflation, which leads to the increase in SRAS shown by shift (2). In the long run, the price level has decreased, but the new output (Y3Y_3) is once again equal to the full employment output (YfY_f).

Common Misperceptions

  • Not every recession needs government intervention, nor does every economic boom. Once prices adjust, the economy should return to the full employment output. Of course, the historical evidence of the Great Depression tells us that sometimes this self-correction mechanism breaks down. We’ll talk more about why that breakdown occurs in upcoming lessons.
  • It can be confusing to remember what is changing to cause the self-correction mechanism. Keep in mind that changes in SRAS drive the self-correction mechanism. As resource and output prices adjust to changes in the rate of inflation and unemployment, SRAS will shift to close an output gap.

Discussion questions

  • The economy of Johnsrudia is experiencing a positive output gap caused by an increase in consumption. Describe the chain of events that would lead the economy to return to producing its full employment output.
When consumption increases, this will cause AD to increase. The price level will increase as a result. Higher inflation will lead businesses and workers to believe that prices will be higher in the future as well, and so wages increase. The change in expectations and input prices will lead SRAS to decrease. This will return output to the full employment level, and the unemployment rate will return to the natural rate of unemployment.
We can use short-hand to describe this chain of events too:
Consumption \uparrow
\rightarrow AD \uparrow
\rightarrow inflation \uparrow, output \uparrow, unemployment \downarrow
\rightarrow increase in inflation expectations
\rightarrow SRAS \downarrow \rightarrow Y=Yf, UR=URn.
  • What might prevent the self-correction mechanism from occurring?
  • During the 2008 recession in the United States, a decrease in consumption and investment spending lead to a decrease in aggregate demand. Describe the chain of events that would lead the economy to return to a long-run equilibrium.