Long run self adjustment
A demand shock has a short-run effect on an output and unemployment, but in the long run only the price level will be impacted. If there is an increase in aggregate demand, the price level will go up. Once wages have adjusted to that inflation in the long run, SRAS decreases and returns the economy to full employment output. Shocks do not cause economic growth, only changes in full employment output cause economic growth.
Want to join the conversation?
- Is it normal that the Price level has increased so much?
How is this different than stagflation? We have a decrease in output (GDP) but an increase in price (inflation), and we're back to full employment (the equilibrium)?(3 votes)
- Typically an increase in aggregate demand and output is associated with an increase in the price level. How much of an increase in the price level will occur depends on how responsive these curves are to changes. That said, however, any increase in the price level will cause people to adapt their expectations about inflation. That shift in short-run aggregate supply curve reflects the adaptation.
However, the shift of the SRAS curve back until the economy is back in long run equilibrium is not stagflation. That terms is normally reserved for the situation where there is inflation but also output *less* than full employment output. When the economy returns to long-run equilibrium, it is *equal* to full employment output.(4 votes)
- I'm still puzzled by how long-term self-adjustment will happen after economy experienced supply shock that left LRAS intact (like maybe firms have less confidence in the future of economy)(2 votes)
- Hello! First of all, you need to focus on factor markets and input prices for firms. Keep that in mind.
A) If the economy is to the left of the LRAS (recessionary gap), what happens is that there is less demand (from firms) in factor markets, and if you remember your first economic lesson, supply and demand, the prices for inputs like raw materials and labor will go down, costs will go down, and firms will start producing more. This represents a SRAS shift all the way back to LRAS. However, it is crucial to note that wages are sticky downwards, because who likes pay cuts? Workers will resist any wage lowerings. That can really slow recovery down, especially since wages account for 70% of the average firm's costs.
Then, B) If the economy is producing more than is sustainable (inflationary gap), firms will compete for the ever-more-needed resources (such as labor), and costs will go up. You'll see this as a leftward shift of SRAS because firms won't be able to produce as much at a given price.
Hopefully I've explained to you the self adjustment mechanism well enough!(4 votes)
- In the beginning,4:40aggregate demand shifted up based on consumer sentiment alone. With no money supply increase, tax break or big government deficit spending built into this example to spur that aggregate demand increase :
Shouldn't prices adjust back to where they were?
Does the self adjustment model really posit that in the long run, after an euphoric surge in AD, we get the same GDP, same amount supplied, same amount demanded but a higher price with no monetary explanation?(2 votes)
- Yes, it does. It might seem a little counterintuitive, but you should know that MV=PY. Money supply times velocity is equal to prices times real GDP. In other words, the amount of money spent in one year is equal to the nominal GDP, or income=expenditures=output. You may also remember that from one of your first macroeconomic lessons. Anyways, the increase in consumer spending causes the velocity of money to go up, how many times your typical dollar bill is exchanged. Anyways, that shows up as the shift in AD, and you'll realize that higher demand leads to firms competing over resources like labor and input prices going up, and SRAS goes back down to where AD=LRAS. My explanation wasn't too clear, but if you think about it for a bit, maybe you'll see it.(2 votes)
- Good day my gracious teacher!
I have studied economics for many years to improve my financial investment ability.
I have read two different sets of micro¯o economics textbooks. There are few questions always bothered me and I can't figure out the answer no matter how hard I have tried. So I come here to re-study your lessons and seek help.
Question2: In the AD&AS model you exhibited a long-run case: in the long-run, if the government do nothing to the economy shock, AD&AS will re-balance in the new equilibrium. Therefore in the long term according to the AD&AS adjustment, the shock will be assimilated, the real GDP(output) will not be affected, only the price level goes up in the new equilibrium.
How could this scenario be possible? Especially if the economy runs under the gold standard monetary system when money supply is limited. How could price level goes up if you can't inject more money into the economy?(2 votes)
- Because there is less supply so the price level goes up because there is more demand for the smaller supply(1 vote)
- It seems to me implausible that after significant shifts in SRAS and AD, involving changes like people changing work arrangements, supply chains running at new levels, factories running at different paces for long enough to arrive at the threshold of "the long run", that the LRAS will have stayed put like an anchor. Does history support this contention? GDP is dynamic, no?(2 votes)
- If there is an increase in resources, such as an increase in oil, the LRAS will shift right. How would that affect the AD and SRAS?(1 vote)
- That's hard to say without making some assumptions. On the one hand, you might say that SRAS will also increase. If there are more resources, then the supply of those resources in factor markets increase, which would lower the cost of production, which would shift SRAS to the right.(2 votes)
- Is it only the supply curve that moves to adjust?(1 vote)
- Is it always the SRAS that shifts in long run self adjustment?(1 vote)
- Not necessarily. Economics teachers often hold that only SRAS shifts to keep the equation simple. In real life, AD may also adjust, depending on what economic school of thought you ascribe to. However, for the sake of most macro courses, this will hold true.(1 vote)
- Didnt understand single thing(1 vote)
- [Instructor] What we have depicted here is an economy in long-run equilibrium. Notice, the point at which the aggregate demand curve and the short-run aggregate supply curve intersect. That specifies an equilibrium price level, PL sub one, and an equilibrium level of output, this equilibrium level of output, Y sub one. But notice, that point of intersection, it also intersects the long-run aggregate supply curve. And so that is also our full employment output. And just a reminder, full employment output does not mean that everyone in the economy is employed. It means that this is the level of employment that is sustainable, the level of full employment. If for some reason the unemployment rate were to get lower than that, that that would be an unsustainable situation for this economy. But what we really care about in this video is what happens if our aggregate demand curve shifts in the short-run and in the long-run? So let's just imagine there's all sorts of positive news and aggregate demand shifts up. So let's imagine, so let me just shift our aggregate demand curve. So it shifts like that. So all of a sudden everyone has become more optimistic, and at a given price level, they just want to demand more output. Well what's going to happen in this universe? Well in this universe, we have a new short-run equilibrium. So we are now right over there. Let's call this, let's call this price level two, and then this is output level two. So Y sub two here. And so what happened? Well in the short-run, we see that prices are going to go up. The suppliers of the output are gonna say hey, hey, all these people want my output, now I'm gonna charge more for it. And I'm also going to increase output. I was like hey there's a bonanza going on. People are not only, not only are they demanding more, but they're willing to pay for it more. And so our output actually goes beyond our full employment output. And so you can imagine maybe unemployment goes below the sustainable rate. All sorts of people instead of going to school they're getting a job or whatever else. They're coming out of retirement to work because there's just a bonanza going on. But what's gonna happen in the long-run? Well in the long-run people who are working and say gee you know, my firm is having this bonanza. When my employment contract comes due, I'm gonna ask for a raise. And so as labor prices go up, what's going to happen to the short-run aggregate supply curve? Yes, it is going to shift up as well. And so let's make it shift well up as well. People are gonna demand more and more and more and more and more and more money all the way to the point that we get to our sustainable level of output again. And so what really happened is, at first, we had this price inflation and output increased beyond a sustainable level. And then people say hey no no no, I want, you know I want more for my time, and so as wages went up, then prices went up even further. And so we get back to, and if prices are going up even further, then even with this shifted aggregate demand curve, people say well I might not want that much of it anymore, and then we shift back to this point right over here. And so now if this was aggregate demand two after everyone got all optimistic, we will call this short-run aggregate supply two. And our equilibrium price now is a good bit higher, price level three, but we are back to our full employment output. So we could call this Y sub three, which is the same thing as Y sub one, which is equal to our full employment output. And what you have just seen, this is known as the long-run self-adjustment mechanism. It's an argument that economists will sometimes make using this simplified model to say hey, if you're in a situation that's either above your full employment output or below your full employment output, it's okay, it will in the long-run self-adjust. Government might not have to intervene. In future videos or in other videos, we'll talk about how a government might wanna intervene in either direction. But this is an argument that's saying well look, that in the short-run things might deviate from your full employment output, but in the long-run they're going to, there's natural mechanisms that will allow output to get back to your natural potential, your full employment output.