Macroeconomics
through which these imbalances or output gaps are corrected as prices (especially wages) become flexible allowing the economy to achieve long-runequilibrium. Let’s examine how the self-correction adjustment process closes both recessionary and inflationary gaps. Self-Correction of Recessionary Gap Witharecessionaryoutputgap,actualoutputorshort-runequilibriumis lessthan thefull-employment level of output (Y₁ < Y f in the diagram below). This means that resource marketshavesurplusesand labor is not fully employed .
In this case, the original short-run equilibrium is at point A.
This recessionary gap is most likely duetoadecreaseandshiftoftheAD curve to the left (e.g., lower consumptionduetounemployment). Sincewagesandresourcepricesare inflexible in the short run, they do not decrease enough to eliminate unemployment and achieve equilibrium in the labor market (whereby the demand for labor = supply of labor). In other words, since someinlaborareunemployed (low demand for labor),laborprices should decrease (recall the law of demand); however, sincewagesand prices are sticky in the short run, they do not.
However, in the long run, wages and resource prices become flexible and fall enough to eliminate imbalancesinthelabormarket. Asaresultofdecliningwagesandotherresourceprices,production costs decrease. Adecreaseinproductioncosts increasesSRASshiftingitscurvetotheright untilit intersects both the AD and LRAS curves at point B where the recessionary gap is closed and the long-run equilibrium is achieved . Self-Correction of Infationary Gap With an inflationary output gap, actual output or short-run equilibrium is greater than the full employment level of output (Y₁ > Y f in the diagram below). This means that resource markets have shortages and labor is overemployed.
In this case, the original short-run equilibrium is at point A.
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