Unit 3 · Topic 3.7 · about 30 minutes · 7 parts · 10 scored checks, 2 of them multiple choice, plus 2 from earlier lessons
AP Macroeconomics 3.7: Long-Run Self-Adjustment
Unit 3: 17 to 27% of the multiple-choice section
What you'll be able to do
- Explain how output, employment and the price level respond in the long run to a shock to aggregate demand or aggregate supply, using a graph where it helps.
Key vocabulary
| Term | What it means | The exam trap |
|---|---|---|
| Long run | The period over which wages and prices are flexible enough to adjust fully to a shock. | Returning to YF does not mean returning to PL1: after an AD shock the price level ends somewhere new, and only after an SRAS shock does it come back to PL1. |
| Flexible wages and prices | Wages and prices that rise or fall in response to conditions in the economy, as they do in the long run, rather than staying fixed by contracts. | Falling nominal wages shift SRAS right, not AD and not LRAS, so the economy moves back to LRAS rather than LRAS moving to the economy. |
| Full-employment level of output | The real output an economy produces when unemployment is at its natural rate; LRAS is vertical at this level. | Nothing about a gap changes this level, so a recessionary gap closes when output comes back to YF, not when LRAS moves left to meet output. |
| Natural rate of unemployment | The unemployment rate that would exist when the economy produces full-employment real output, equal to the sum of frictional and structural unemployment. | Unemployment returns to the natural rate after self-adjustment, not to zero: cyclical unemployment is gone, but frictional and structural unemployment remain. |
| Long-run aggregate supply (LRAS) | The vertical curve at the full-employment level of output; a shift of it means full-employment output has changed. | Only a change in resources or technology shifts LRAS, so a one-year jump in fuel prices shifts SRAS and leaves LRAS where it is. |
| Economic growth | An increase in the full-employment level of output, shown by the LRAS curve shifting to the right. | Growth here means LRAS shifting right, so rising real GDP as an economy climbs out of a recessionary gap is a return toward YF, not economic growth. |
Tap to open the picture full sizePart 1 Think first A slump with no rescue
Guess before you learn. A wrong guess still makes the answer stick.
Predict first
A country falls into a deep recession, and unemployment climbs well above normal. Neither the government nor the central bank does anything about it: no new spending, no tax changes, nothing. Over the next couple of years, what most likely happens to the pay employers offer when they hire?
In short. Long-run self-adjustment is how an economy returns to full employment after a shock to aggregate demand or short-run aggregate supply when no policy action is taken.
- When output is away from full employment, input prices such as nominal wages, and inflationary expectations, adjust, and that shifts SRAS, not AD.
- The economy settles where AD meets LRAS, with unemployment back at its natural rate; where the price level ends depends on which curve the shock moved.
- A shift of LRAS itself is a change in full-employment output, and a rightward shift is economic growth.
Part 2 Learn it Four short ideas, each checked as you go
2a. Closing a recessionary gap on its own
Say a negative shock to aggregate demand has pushed real output below full employment, to the left of LRAS. Unemployment is above its natural rate. Now suppose no one takes any policy action.
In the short run many wages and prices are stuck; over a longer stretch they are flexible. With more people looking for work than there are jobs, workers accept lower pay and new contracts come in lower. Suppliers of other inputs cut their prices to keep customers, and people come to expect less inflation. So input prices (e.g., nominal wages) and/or inflationary expectations decrease.
Lower costs let firms supply more at every price level, so SRAS shifts right. It keeps shifting as long as output is below full employment, and it stops when SRAS crosses AD on LRAS. Output is back at YF, unemployment is back at its natural rate, and the price level is lower than PL1, because the crossing slid down AD.
AD stayed where the shock left it. Only SRAS does the adjusting.
Quick check · Put it in order
Household spending drops sharply, and the economy falls into a recession. No policy action is taken. Tap the steps in the order they happen.
2b. The inflationary gap, and what does not do the adjusting
A positive shock runs the same process the other way. Say a surge in spending pushes real output above full employment, to the right of LRAS, and unemployment below its natural rate. Firms are short of workers and bid against each other, so nominal wages rise. Other input prices rise, and people come to expect more inflation. Input prices (e.g., nominal wages) and/or inflationary expectations increase, so SRAS shifts left until it crosses AD on LRAS. Output falls back to YF, unemployment rises back to its natural rate, and the price level ends higher than PL1.
Self-adjustment means no policy at all. The government does not change its spending or taxes, and AD stays where it is. Two explanations sound right and are not this process: AD "shifting back", and automatic stabilizers, the tax and transfer changes that happen on their own as incomes move (they are the topic of 3.9). Both are about spending. Self-adjustment is about costs.
An inflationary gap closes with no policy
Output starts at Y1, past full employment. As wages rise, SRAS shifts left to SRAS2, and AD meets it on LRAS at YF, with PL2 above PL1.
Quick check · Decide and justify
A boom in foreign tourism has pushed Sarnia's real output above full employment. No policy action is taken. As Sarnia adjusts in the long run, what happens to short-run aggregate supply?
Which reason supports your choice?
2c. Supply shocks heal too
The same process closes a gap that a supply shock opens, with one difference in where the price level ends.
Start in long-run equilibrium. A sharp rise in the price of a widely used input shifts SRAS left. In the short run (3.6), output falls below YF, unemployment rises above its natural rate, and the price level rises above PL1.
Now the recessionary gap does what any recessionary gap does. Unemployment is above the natural rate, so nominal wages and other input prices fall, and SRAS shifts back to the right. AD never moved, so the only point on both AD and LRAS is the point the economy started from. Output returns to YF and the price level returns to PL1.
One tempting stop is wrong: the point where SRAS2 crosses LRAS. It is not on AD, so it is not an equilibrium, and SRAS keeps shifting past it.
A positive supply shock runs the mirror image. SRAS shifts right, output rises past YF, wages rise, and SRAS shifts back left to where it began.
Quick check · Multiple choice
An economy is in long-run equilibrium when the world price of copper, used in wiring, pipes and machinery, rises sharply. Full-employment output does not change, and no policy action is taken. Once the economy has fully adjusted, how do real output and the price level compare with their values before the copper shock?
2d. When LRAS itself moves
Everything so far moved SRAS and left LRAS alone, because a gap is about costs and spending, not about what the economy is able to produce. LRAS sits at the full-employment level of output, and it shifts only when that level changes.
It shifts right when the economy can produce more at full employment, for example because it has a larger labor force or more capital. That rightward shift is what economic growth looks like on the AD-AS graph, and it is the picture at the top of this page. It shifts left when productive capacity is lost, as when a war or a natural disaster destroys factories and roads.
Keep this apart from self-adjustment. When wages fall in a recession, LRAS does not move over to meet the economy. The economy moves back to LRAS, through SRAS. Ask one question: did the economy's resources or technology change? If not, LRAS stays where it is.
Quick check · Sort it
Tap an event, then tap what it does to the long-run aggregate supply curve.
LRAS shifts right
LRAS shifts left
LRAS does not shift
Part 3 Watch it done Ravelstone's slump, with no policy
Watch each step, then do the last one yourself.
A sharp fall in consumer spending has left Ravelstone, a fictional economy, with real GDP of $820 billion. Its full-employment real GDP is $860 billion. Unemployment is 7.1%, and the natural rate of unemployment is 4.8%. The government takes no policy action. Explain how Ravelstone returns to long-run equilibrium, and say where it ends up.
Step 1 · Name the gap
Real GDP is $40 billion below full-employment output, a negative (recessionary) gap. On the graph, Y1 sits to the left of LRAS, and unemployment is above the natural rate.
Step 2 · Find the cause
With 7.1% of the labor force out of work against a natural rate of 4.8%, there are more workers than jobs. Over time nominal wages and other input prices fall, and inflationary expectations fall, so production costs fall for most firms.
Step 3 · Shift SRAS
Lower costs let firms supply more at every price level, so SRAS shifts right, from SRAS1 to SRAS2. AD stays where the fall in spending left it.
Why this step?
Why does SRAS move, and not AD?
Falling wages and input prices change what it costs firms to produce, which is supply. Nobody's spending plans changed, and with no policy, nothing shifts AD.
Your step · Fill the statement
Finish the analysis. Tap a blank, then tap a value or a phrase.
Once Ravelstone is back in long-run equilibrium, real GDP is , the price level is PL1, its level before household spending fell, and the unemployment rate is .
Ravelstone's adjustment on the graph
Output starts at Y1, short of full employment. As wages and input prices fall, SRAS shifts right to SRAS2, and AD meets it on LRAS at YF, with PL2 below PL1.
Part 4 Try it Run the long run yourself
Try it · Match
Each shock hits an economy that starts in long-run equilibrium, and no policy action follows. Tap a shock, then tap what happens in the long run.
Part 5 Explain it Write it the way the exam asks
Nothing you type leaves this page.
Free response is 33.35% of the exam score. This one is shaped like Question 1, Long.
Free-response practice · Question 1 style
Westmere, a fictional economy, has an unemployment rate of 7.4%. Its natural rate of unemployment is 4.9%.
(a) Draw a correctly labeled graph of aggregate demand and aggregate supply showing each of the following: (i) the current equilibrium price level, labeled PL1, and real output, labeled Y1; (ii) the long-run aggregate supply curve, labeled LRAS, at full-employment output, labeled YF.
(b) Assume no policy action is taken. Explain how the economy will return to long-run equilibrium.
(c) On your graph in part (a), show the long-run adjustment, labeling the new equilibrium price level PL2.
Model answer
(a) Price level on the vertical axis and real output on the horizontal. AD slopes down and SRAS1 slopes up, crossing at PL1 and Y1, both marked on the axes. Unemployment of 7.4% is above the natural rate of 4.9%, so output is below full employment: LRAS is vertical to the right of Y1, labeled YF. (b) Because unemployment is above the natural rate, input prices (e.g., nominal wages) and/or inflationary expectations will decrease, causing SRAS to increase until it reaches full employment. (c) SRAS2 is drawn to the right of SRAS1, with an arrow showing the shift, and crosses AD on LRAS at YF; PL2 is marked on the axis below PL1.
Score your own answer. This is a self-check, not a grade. Tick each point your answer makes.
Part 6 Check yourself Read a gap from the data
Read the table first, then answer both questions from it.
Marrowvale, a fictional economy, reported these figures for this year. No policy action is planned.
| Measure | This year |
|---|---|
| Real GDP (billions of dollars) | 1,315 |
| Full-employment real GDP (billions of dollars) | 1,250 |
| Unemployment rate | 3.2% |
| Natural rate of unemployment | 4.6% |
| Price level (index) | 112 |
Case question 1 · Multiple choice
Marrowvale's real GDP is $1,315 billion, its full-employment real GDP is $1,250 billion, and its price level is 112. Once it has returned to long-run equilibrium with no policy action, how will its price level compare with 112?
Case question 2 · Calculate
Marrowvale's unemployment rate is 3.2% and its natural rate of unemployment is 4.6%. Once it has returned to long-run equilibrium with no policy action, what will its unemployment rate be, in percent?
The rest stand on their own and do not use the case.
Check yourself · Spot the error
A student explained how an economy with a recessionary gap returns to full employment when no policy action is taken. Tap the first line that goes wrong.
Check yourself · Put it in order
An economy is in long-run equilibrium when the world price of natural gas, which fuels power plants and heats factories, rises sharply. Full-employment output does not change, and no policy action is taken. Tap the steps in the order they happen.
Part 7 Keep it Keep it
From 3.6 Changes in the AD–AS Model in the Short Run · Sort it
Each event happens on its own in an economy at full employment. Tap an event, then tap the kind of short-run effect it has on the price level.
Demand-pull inflation
Cost-push inflation
The price level falls
From 3.4 Long-Run Aggregate Supply (LRAS) · Decide and justify
An economy's price level rises 15 percent, and over the next few years every wage and input price rises 15 percent as well. In the long run, does the economy produce more real output than it did before the price level rose?
Which reason supports your choice?
In three lines
- Recessionary gap: input prices (e.g., nominal wages) and/or inflationary expectations fall, SRAS shifts right, and the price level ends lower.
- Inflationary gap: they rise, SRAS shifts left, and the price level ends higher; after a supply shock it returns to where it started.
- AD, the government and automatic stabilizers play no part; LRAS shifts only when full-employment output changes.
Exam strategy for this topic
- Section I, Multiple Choice: 60 questions in 70 minutes.
- Section II, Free Response: 3 questions in 60 minutes.
- This lesson's Explain it is shaped like free-response question 1, Long.
- A four-function calculator is allowed on both sections of the exam.
Name the gap from the numbers, then give the cause before the shift: input prices (e.g., nominal wages) and/or inflationary expectations fall or rise, so SRAS shifts. Draw SRAS2 crossing the unchanged AD on LRAS and mark PL2 on the vertical axis.
Questions students ask
Where does the price level end up after a recessionary gap closes on its own?
It depends on what opened the gap. After a drop in AD, SRAS shifts right down the unchanged AD, so the price level ends below PL1. After a supply shock, SRAS shifts back to where it started, so the price level returns to PL1.
After a supply shock, why doesn't the economy stop where SRAS2 crosses LRAS?
That point is not on AD, so it is not an equilibrium. Unemployment is still above the natural rate, wages keep falling, and SRAS keeps shifting right until it is back at the starting point.
In a recession, does LRAS move over to meet the economy?
No. LRAS moves only when the economy's resources or technology change. The economy moves back to LRAS through SRAS.
What unemployment rate does the economy end at?
The natural rate. If unemployment is 3.2 percent and the natural rate is 4.6 percent, rising wages shift SRAS left until output falls back to YF, and unemployment rises to 4.6 percent.
What does economic growth look like on the AD-AS graph?
LRAS shifting right, because the economy can produce more at full employment, for example with a larger labor force or more capital.
Course alignment, for teachers
AP Macroeconomics topic 3.7, Unit 3: National Income and Price Determination.
- Skill 3.A: Determine the outcome of an economic situation using economic concepts, principles, or models.
This lesson maps all 2 essential knowledge statements of the topic to the part that teaches each one: 2 are checked by a scored question. The map is in the lesson file.