When AD shifts, the economy can land in a recessionary or inflationary gap. With no policy, nominal wages and other input prices slowly adjust, SRAS shifts, and real GDP returns to full-employment output. Create a gap with the AD slider or a scenario, then press Let the long run play out and watch SRAS do the work.
Dashed grey lines show where the economy started: long-run equilibrium E₁ at full-employment output Yf = 1,000 and price level 100. Solid lines show where it is now.
| Curve | During self-adjustment |
|---|---|
| AD | |
| SRAS | |
| LRAS | |
| Nominal wages | |
| Unemployment |
In the long run, real GDP returns to full-employment output on its own. The adjustment happens through SRAS, because nominal wages and other input prices eventually catch up with the price level.
Output is below Yf and unemployment is above the natural rate. Over time, workers accept lower nominal wages and input prices fall. Lower costs shift SRAS right, the price level falls, and real GDP rises back to Yf.
Output is above Yf and unemployment is below the natural rate. Workers are scarce, so nominal wages and input prices rise. Higher costs shift SRAS left, the price level rises further, and real GDP falls back to Yf.
After self-adjustment, real GDP is back at Yf. The only lasting effect of the AD shift is a different price level: lower after a fall in AD, higher after a rise in AD.
Wage contracts, minimum wage laws, and workers' resistance to pay cuts slow the adjustment, especially downward. Wages are slower to fall than to rise, so recessions can drag on.
Waiting can mean years of high unemployment or rising prices. Fiscal and monetary policy can shift AD back toward Yf faster, which is the case for stabilization policy in topics 3.8 and 4.6.
Memorize both rows. Each one is a full FRQ answer: the gap, what wages do, which way SRAS moves, and where the price level and real GDP end up.
| Starting gap | Real GDP vs. Yf | Unemployment | Nominal wages and input prices | SRAS shift | Long-run price level | Long-run real GDP |
|---|---|---|---|---|---|---|
| Recessionary gap (after AD falls) | Below Yf | Above the natural rate | Fall | Right | Falls further (below PL₁) | Rises back to Yf |
| Inflationary gap (after AD rises) | Above Yf | Below the natural rate | Rise | Left | Rises further (above PL₁) | Falls back to Yf |
| Long-run equilibrium | Equal to Yf | Equal to the natural rate | No pressure to change | None | Stays put | Stays at Yf |
| Recessionary gap closed by expansionary policy | Below Yf | Above the natural rate | Do not need to fall | None (AD shifts right instead) | Returns to about PL₁ | Rises back to Yf |
| Inflationary gap closed by contractionary policy | Above Yf | Below the natural rate | Do not need to rise | None (AD shifts left instead) | Returns to about PL₁ | Falls back to Yf |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 3.7. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 3 terminology guide.