- Classical economists believe that in the long run the economy will always return to its full potential level of output and all that will change is the average price level
- This is the also referred to as the self-correcting mechanism
Automatic adjustment from a deflationary output gap
- A deflationary (recessionary) output gap occurs when the real GDP is less than the potential real GDP
Aggregate demand (AD) has shifted left causing a deflationary gap, which in the long-run will self-correct to YFE but at a lower average price level (AP2)
Correction Process
- Initial long-run equilibrium is at AP YFE
- AD shifts left from AD → AD1, possibly due to the onset of a recession
- Output falls from YFE → Y1 and price levels fall from AP → AP1
- Due to the fall in output, firms lay off workers
- Unemployed workers are now willing to work for lower wages and this reduces the costs of production which causes the SRAS curve to shift right from SRAS1 → SRAS2
- A new long-run equilibrium is formed at AP2 YFE
- The economy is back to the full employment level of output (YFE), but at a lower average price
Automatic adjustment from an inflationary output gap
- An inflationary output gap occurs when real GDP is greater than the potential real GDP
Aggregate demand (AD) has shifted right causing an inflationary gap, which in the long-run will self-correct to YFE but at a higher average price level (AP2)
Correction Process
- Initial long-run equilibrium is at AP YFE
- AD shifts right from AD1 → AD2, possibly due to raid expansion of the money supply
- Output rises from YFE → Y1 and price levels rise from AP → AP1
- Due to the increase in average prices (inflation), workers demand higher wages
- Higher wages increase the costs of production which causes the SRAS curve to shift left from SRAS1 → SRAS2
- A new long-run equilibrium is formed at AP2 YFE
- The economy is back to the full employment level of output (YFE), but at a higher average price