Long Run Self Adjustment

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 the supply of loanable funds. This decreases the interest rates in the economy, and borrowing money becomes cheaper for US citizens. As the interest rate decreases, investment spending and consumer spending increase. Money is cheap; why not buy a house or open up a business? This causes the aggregate demand curve to shift to the right (from AD₁ to 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 E₁ to E₂). The change in equilibrium results in higher output(Y₂) and higher prices(P₂). As the price increases (from P₁ to P₂), there is a movement along with the short-run aggregate supply (from E₁ to E₂) as higher prices incentivize businesses to start producing more (from Y₁ to 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 SRAS₁ to SRAS₂), as seen in figure 4.

Fig 4. - Long-run self-adjustment

Figure 4 points to the shift in SRAS (from SRAS₁ to SRAS₂) due to an increase in wages. Businesses start producing less (from Y₂ to 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:

$Outputgap=\frac{Actualaggregateoutput-Potentialoutput}{Potentialoutput}\times 100$

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

Inflationary gaps typically occur due to an increase in aggregate demand(from AD₁ to AD₂). During an inflationary gap, aggregate demand shifts the price level (from P₁ to P₂). This price increase can mislead some into thinking there's an increase in output(Y₂); this leads to an increase in nominal GDP; however, real GDP stays the same.

Concerning the long-run self-adjustment process, the inflationary gap will cause the SRAS to shift to the left, causing the overall equilibrium to restore in higher prices and lower output.

Recessionary gap

Recessionary gaps are periods in the economy associated with a decline in the price level and the overall production in the economy. The most significant disadvantage of recessionary gaps is that they increase unemployment in the economy. As the output falls in the economy, businesses don't need as many as employers to keep up with demand; therefore, they lay off some of them.

Fig 6. - Recessionary gap

Figure 6 shows a recessionary gap caused by a leftward shift in aggregate demand. The output decreases (from Y₁ to Y₂), while the price level falls (from P₁ to P₂).

Regarding the long-run self-adjustment, a recessionary gap causes the short-run aggregate supply to shift to the right, as the decrease in price level makes it cheaper to hire more workers and produce more. The equilibrium is restored at the full employment output, but the economy's prices will further decrease.

Benefits of Long-Run Self-Adjustment

There are many benefits to long-run self-adjustment; the economy goes back to its full potential output due to the long-run self-adjustment mechanism of the economy. A supply or demand shock that causes fluctuations in the economy will cause either an increase in output associated with inflation or a drop in production for a recession.

As the economy is above or below its full potential output, it means that the economy is not using its entire resources efficiently. Having a mechanism that self-corrects the economy and brings the equilibrium to the point where full potential employment of resources is used at an equilibrium price level. That is because it enables a much more efficient allocation of resources.

Another benefit of the long-run self-adjustment process is that there is no need for government policy. That doesn't mean that government policy is terrible; however, it mitigates the risk of the government choosing the wrong policy, which could mess with the equilibrium in the economy even more. Sometimes, the government might not find the right approach to address a shock in the economy. The process of the economy self-correcting itself is a better choice, as the market clears under the conditions and needs of the current situation.

The Theory of Long-Run Self-Adjustment

The main concept of the theory of the long-run self-adjustment is if the economy experiences fluctuations, it will naturally self-correct itself to its full-employment output in the long run. That means that market disruptions in the economy matter more in the short run. The long-run self-adjustment theory suggests that regardless of whether there is a positive or negative shock in aggregate demand or aggregate supply, market forces will bring the equilibrium back. Additionally, the theory of long-run self-adjustment suggests that the government should not intervene in the market when there is an economic shock.