Chapter 9 · Aggregate demand and aggregate supply
Automatic adjustment: inflationary gap
Follow an AD rise and the classical adjustment to an inflationary gap: higher wages and costs shift SRAS left, returning output to potential.
The economic idea
Aggregate demand is total planned spending on domestic output at different average price levels: consumption, investment, government expenditure and net exports. Short-run aggregate supply is the real output firms are willing and able to produce at those price levels while some input prices adjust slowly.
Macroeconomic equilibrium is the intersection of aggregate demand and aggregate supply. In the monetarist/new classical model, long-run aggregate supply is vertical at potential output: the sustainable output associated with the economy’s resources, technology and normal capacity use. Full employment does not eliminate frictional and structural unemployment.
An inflationary gap exists when actual real output exceeds sustainable potential output. A recessionary gap exists when actual output is below potential. An output gap concerns levels of real output; it is not itself a measure of the inflation rate.
Automatic adjustment is the response of short-run aggregate supply to an output gap, rather than a deliberate fiscal or monetary policy. Above potential, firms compete for scarce workers and inputs. Rising nominal wages and unit costs reduce SRAS. Below potential, weaker demand for inputs can lower costs and increase SRAS if nominal prices are flexible.
With aggregate demand and potential output unchanged, the process can return output toward long-run equilibrium. It is conditional, not immediate or guaranteed: contracts, bargaining, expectations and institutional rigidities affect whether the required cost adjustment occurs.
Stage one: full employment before the spending increase
“Price level” measures the average price level; “Real GDP” measures real output. “LRAS” marks potential output.
“AD₁” is aggregate demand before the shock. “AD₂” is its position after the shock; it is held fixed during the later cost adjustment.
“SRAS₁” is the original supply curve. “SRAS₂” is introduced only in the cost-adjustment stage; hidden future curves are not missing diagram objects.
Stage one: full employment before the spending increase
“AD₁” and “SRAS₁” meet at “E₀” on “LRAS”. Actual real GDP equals potential output “Yf” at price level “PL₀”. There is no output gap at this starting point; full employment can still include frictional and structural unemployment. The demand shock and cost adjustment have not been shown yet.
Next: what would change AD?
A change in consumption, investment, government spending or net exports can shift AD. The next stage shows this demand shock while SRAS is initially unchanged.
What can we conclude now?
The current graph establishes the starting full-employment equilibrium only. It does not yet show a demand shock, a recessionary or inflationary gap, or an SRAS adjustment.
Why automatic adjustment is different from a policy response
In an inflationary sequence, higher spending shifts AD right first. Strong demand for labour and other inputs can then raise nominal wages and costs, shifting SRAS left. This is a cost response to output above potential, not a government decision to reduce aggregate demand.
The current stage shows the starting equilibrium. The sequence above explains what to test next; it does not mean that a shock or cost adjustment is already visible.
Common mistakes to avoid
- AD changes from “AD₁” to “AD₂” when the shock creates the gap. During automatic adjustment, keep “AD₂” fixed and explain why nominal costs shift SRAS.
- Do not describe a later stage as if it is already on the current graph. A selected cost-adjustment stage with zero movement has not closed a gap.
- A recessionary adjustment lowers the price level; that is not the same as saying the inflation rate must remain negative over the entire process.
- An inflationary adjustment returns real output to potential; it does not shift “LRAS” left or destroy capacity by assumption.
- Full employment still allows frictional and structural unemployment.
- Automatic does not mean immediate or guaranteed. Wage and price rigidity can make the process slow, costly or incomplete.
How to draw this diagram
- Label the axes Price level and Real GDP. Draw AD₁, SRAS₁ and vertical LRAS meeting at initial full employment E₀.
- Shift AD to AD₂ to show the specified spending shock. Keep SRAS₁ and LRAS fixed and label the short-run equilibrium E₁ and its output gap.
- Keep AD₂ and LRAS fixed. Explain the nominal wage/input-cost response, then draw SRAS₂ in the justified direction.
- Mark the adjusted equilibrium E₂ and project its price level and real output to the axes. Place it on LRAS only when the displayed adjustment actually closes the gap.
Assumptions and limitations
- Nominal wages may be downwardly rigid because of contracts, minimum wages, bargaining, morale and efficiency-wage considerations.
- Falling prices during recession can raise real debt burdens and weaken spending, shifting AD left and offsetting the predicted recovery.
- Expectations may be adaptive, anchored or unstable rather than adjusting smoothly.
- A prolonged output gap can alter investment, labour-force participation and skills, shifting LRAS rather than leaving potential output fixed.
- Policy often changes before adjustment is complete, so real outcomes can combine SRAS adjustment with AD shifts.