After a shock, the economy may sit in a gap. If no one changes policy, does it stay there? In the AD–AS model the answer is no, eventually, because sticky wages and prices do not stay sticky forever.
🔑 Key idea
In a recessionary gap, unemployment is high, so over time nominal wages and other input prices fall; SRAS shifts right until output returns to full employment at a lower price level. In an inflationary gap, wages rise; SRAS shifts left until output returns to full employment at a higher price level. The self-correcting move is a shift of SRAS, not of LRAS or AD.
💡 Why it works
Wages respond to the job market. With many people looking for work, firms can fill jobs at lower pay, and workers accept smaller raises; as labor costs fall, firms produce more at every price level. With labor scarce, the reverse happens. In both cases the adjustment stops only when output is back at potential, because only there is the job market neither slack nor tight. LRAS does not move: capacity did not change.
Step through the adjustment: AD falls, then wages fall and SRAS shifts right in stages until output is back on LRAS.
Worked examples
✏️ Worked example: The long-run price level
AD is $P = 180 - 5Y$ (trillions) and full-employment output is 12. Right now SRAS crosses AD at $Y = 10$. If AD stays put, where does the economy end up?
Output below 12: a recessionary gap, so wages fall and SRAS shifts right.
The economy ends where AD meets LRAS: $Y = 12$, $P = 180 - 5(12) = 120$.
The price level falls from $180 - 5(10) = 130$ to 120.
Answer: $Y = 12$, $P = 120$
✏️ Worked example: An inflationary gap
Output is above potential. With no policy change, what happens?
Labor is scarce, so nominal wages rise.
SRAS shifts left until output returns to potential, at a higher price level.
Answer: SRAS shifts left; prices rise; output returns to potential
How fast does this happen? Here economists disagree. Many find that wages fall slowly in a recession (because of contracts, minimum wages and concerns about fairness), so adjustment can take years; that is the case for using fiscal or monetary policy to speed recovery. Others stress that policy acts with delays and can overshoot. Both sides agree on the direction of the adjustment; they differ on its speed and on what policy should do.
⚠️ Common mistake
Closing a gap by shifting LRAS or AD. Without policy, the self-correcting move is a shift of SRAS as wages adjust. Check: which curve depends on nominal wages? SRAS.
Practice
Pass with 3 right answers, the last 2 in a row. Each right answer earns 3 XP.