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.
Aggregate demand refers to the total demand in an economy for goods and services.
The short-run aggregate supply in an economy refers to the total amount of goods and services produced during the short run.
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
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 AD1 to AD2). The equilibrium in the AD-AS model changes (from E1 to E2). At this point, there is a lower output produced(Y2), and the prices in the economy drop(P2).
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 SRAS1 to SRAS2). That is because the cost of input (wages) decreases, allowing businesses to produce more.
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 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:
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.
Long-Run Self-Adjustment - Key Takeaways
- The long-run self-adjustment is a procedure through which the economy resets itself to its equilibrium point after a market shock in the economy.
- In the long run, prices and wages are flexible.
- In the long run, the equilibrium is restored at full employment output due to changes in prices and wages.
- Regardless of whether there is a shock in aggregate demand or aggregate supply, it will return to full employment output in the long run.
- A shift in the long-run aggregate supply comes with a change in the full-employment level of output.
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