Chapter 9 · Aggregate demand and aggregate supply
Automatic adjustment: recessionary gap
Follow an AD fall and the classical adjustment to a recessionary gap: lower wages and costs shift SRAS right, returning output to potential.
The economic idea
Automatic adjustment is the process through which flexible nominal wages, input prices and expectations change short-run aggregate supply in response to an output gap, returning actual output toward potential output without an active demand-management policy.
In the monetarist/new classical model, LRAS is vertical at potential output. Aggregate demand determines the long-run price level, while productive capacity determines long-run real output.
A recessionary gap weakens demand for labour and other inputs. If nominal wages and input prices fall, firms’ unit costs decrease and SRAS shifts right/down, raising output and lowering the price level.
An inflationary gap creates shortages of labour and inputs. Rising nominal wages and input prices increase firms’ unit costs and shift SRAS left/up, lowering output and raising the price level.
The process is not instantaneous. Contracts, minimum wages, worker morale, bargaining, imperfect information and expectations can delay or prevent the required nominal adjustment.
Stage one: full employment before the demand slump
“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 demand slump
“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 a recessionary sequence, lower spending shifts AD left first. The classical model then allows weak demand for labour and other inputs to lower nominal wages and costs, shifting SRAS right. This is a possible cost response to the gap, not an increase in government spending or another AD shift.
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.