5 Steps to a 5 AP Macroeconomics 2019

118 ❯ Step 4. Review the Knowledge You Need to Score High

Classical Adjustment from Short-Run to Long-Run Equilibrium

One of   the    toughest    concepts    for students    to   master is   the    way in   which  the AD/AS   model   

presents both a short­run and a long­run equilibrium. Although some economists disagree,

the prevailing treatment in the AP curriculum is that a recessionary or inflationary gap

(a short­run equilibrium) will “self­correct” to a long­run equilibrium once enough time

has passed for all prices to adjust. Let’s see how this can happen.

Adjustment to a Recessionary Gap

Suppose the economy is currently operating at full employment, as shown in Figure 9.17

at the intersection of the AD, SRAS, and LRAS curves with a real GDP of GDPf. Now

suppose that consumers and firms begin to lose confidence in the labor market and overall

economy, causing AD to shift to the left. In the short run, this will cause a recessionary

gap as real GDP falls to GDPr (unemployment rises), and the aggregate price level falls

from PL 1 to PL 2. Ignoring any kind of fiscal or monetary policy intervention (which we

will discuss in the next two chapters), this short­run recessionary gap can self­correct. How

does this happen?

One of the hallmarks of a recession is a decreased demand for many factors of pro­

duction, like labor, steel, oil, and other commodities. This decreased demand for critical

factors of production will eventually decrease the prices of those factors, causing a gradual

rightward shift of the SRAS curve to SRAS 2. The SRAS curve shifts to the right until the

recessionary gap is closed, the economy is back at GDPf, and an even lower aggregate price

level exists at PL 3.

Price

Level

LRAS

Qr Qf

PL 1

AD 2

AD (^1) SRAS
(^1) SRAS
2
PL 2
PL 3
Real GDP
Figure 9.17
Adjustment to an Inflationary Gap
Let’s begin again with long­run equilibrium at a real GDP of GDPf. When we incorporate
an increase in the AD curve, we create an inflationary gap. Figure 9.18 shows that this
increase to AD 2 causes an increase in real GDP to GDPi (a lower unemployment rate) and
an increase in the aggregate price level to PL 2. How would this self­correct?