Module 3.7: Long Run Self Adjustment in the Aggregate Demand and Aggregate Supply Model

Module 3.7: Long Run Self Adjustment in the Aggregate Demand and Aggregate Supply Model

Overview of Economic Debate

  • Discussion revolves around the question:

    • Should governments intervene during economic struggles?

    • Or should they allow economies to heal themselves?

  • Understanding both sides is crucial, as this debate influences real policy decisions affecting millions of lives.

The Two Schools of Thought

Team Intervention

  • Economists believe:

    • Government and/or central bank can stabilize the economy

    • Can prevent unnecessary suffering during economic downturns.

Team Hands Off

  • Economists argue:

    • Economies self-correct over time

    • Policy actions could potentially worsen economic issues.

Key Concepts and Definitions

Long Run Self Adjustment

  • A cornerstone of classical economic thought.

  • Asserts that:

    • An economy, when left to its own devices, will return to full employment or potential output over time.

    • This process is driven by flexibility in wages and prices.

  • These flexible wages and prices act as internal regulators that help smooth out short-term fluctuations in output.

Economic Shocks

  • Defined as unexpected events that significantly change the economy.

  • Can disrupt equilibrium and lead to fluctuations in:

    • Output

    • Employment

    • Price Level

  • Types of economic shocks:

    • Shocks affecting aggregate demand.

    • Shocks affecting aggregate supply.

Price Adjustment Mechanism

  • Allows an economy to self-correct after a shock:

    • Utilizes flexibility in wages and prices.

    • Guides the economy back to its long run equilibrium (potential output).

  • The process varies depending on the type of shock (aggregate demand vs. aggregate supply).

Classical Economic Theory

  • Developed in the 18th and 19th centuries during Western capitalism and the Industrial Revolution.

  • Early attempts to explain the economic system's workings.

  • Classical economists compared economic crises to weather patterns, asserting:

    • Like storms, economic issues pass on their own.

    • Prices and wages were considered fully flexible, returning the economy to normal over time.

Modern Self Adjustment Theory

  • More nuanced than classical thought.

  • Acknowledges that while businesses and workers adjust prices and wages, the return to equilibrium can take years.

  • Quote by John Maynard Keynes:

    • “In the long run, we’re all dead.”

  • Raises ethical question:

    • Should society endure prolonged suffering (inflation, high unemployment) when solutions (government intervention) might exist?

Mechanism of Self Adjustment

  1. Shock Occurrence:

    • Economic shock occurs, impacting either aggregate demand or short-run aggregate supply.

  2. Output Gap Creation:

    • This leads to an output gap, exerting pressure on wages and prices.

  3. Adjustment of Wages and Prices:

    • Wages and prices adjust to this new economic reality over time (which may take years).

  4. Shift in Short-Run Aggregate Supply Curve:

    • The short-run aggregate supply curve shifts, gradually closing the output gap.

  5. Return to Full Employment Output:

    • Eventually, the economy returns to full employment output.

  • Core principle:

    • Shocks affect the short run but not the long run.

  • Note:

    • Self adjustment exclusively involves shifts in the short-run aggregate supply curve.

Example Case: Hampsteadville, Florida

  • Scenario:

    • Town experiences a surge in optimism, leading to increased consumer spending.

  • Short Term Effects:

    • Aggregate demand shifts right, causing increased output above full employment and decreased unemployment.

  • Caveat:

    • Results in inflation, leading to an inflationary gap that cannot be sustained.

  • Graphical Representation:

    • Starts in long run equilibrium; aggregate demand shift leads to higher prices and output in the short run.

  • Inevitably Leads to:

    • Higher price level causes wages to increase, pushing the short-run aggregate supply left.

  • Result:

    • Economy returns to full employment output but at a permanently higher price level.

  • Real-Life Implication:

    • Example of coffee shop price increase from $5 to $5.5 (10% increase). Workers experience real wage decline due to inflation, prompting them to seek better-paying jobs, leading to a general rise in wage levels.

Reverse Mechanism of Self Adjustment

  • When aggregate demand shifts left due to reduced consumer spending or pessimism:

    • Creates a recessionary gap with increased unemployment.

  • Self Adjustment Process:

    • High unemployment exerts downward pressure on wages, reducing production costs.

    • Shifts short-run aggregate supply curve to the right.

    • Economy eventually returns to full employment at a lower price level.

Positive and Negative Supply Shocks

  • Positive Supply Shocks:

    • Yield increased real output, lower unemployment, and lower prices.

  • Negative Supply Shocks:

    • Considered the worst economic events; their consequences vary based on duration (temporary vs. permanent).

    • Temporary Supply Shock (e.g., oil price increase):

    • Shifts short-run aggregate supply left, reducing output, and elevating prices.

    • High unemployment leads to falling wages, allowing the short-run aggregate supply to later shift right, restoring full employment.

    • Permanent Supply Shock (e.g., restrictive regulations):

    • Shifts both short-run and long-run aggregate supply left, resulting in long-term lower output and higher prices.

  • Real-world implications illustrated through examples of regions (e.g., post-Katrina New Orleans and Chernobyl affected areas) that have yet to fully recover.

AP Exam Preparation Tips

  • Break down self-adjustment problems systematically:

  1. Identify Initial Economic Condition:

    • Is it an inflationary gap or equilibrium?

  2. Draw Aggregate Demand and Supply Model:

  3. Show Shock with Curves:

    • Shift aggregate demand/right or short-run aggregate supply accordingly.

  4. Illustrate Self-Correction:

    • Through a shift in the short-run aggregate supply curve.

  5. Identify New Long-Run Equilibrium:

    • Analyze and confirm the self-corrected state.

  • Advise against trying to draw complex graphs all at once; encourage step-by-step tackling of each phase.

Key Takeaways

  • Self-adjustment mechanisms do enable economies to revert to full employment without the need for government intervention, though the process takes time and can take many years.

  • The mechanism functions primarily through a shift of the short-run aggregate supply curve due to wage and price adjustments.

  • Permanent output changes arise only from actual resource changes affecting long-run aggregate supply shifts.

  • The intervention versus patience debate persists in current economic discussions, and understanding different perspectives enriches economic comprehension.

  • Concluding thought: Understanding both sides of the debate equips one with a more rounded perspective as an economist.