AP Syllabus focus: ‘Without government policy, flexible wages and prices adjust over time to restore full-employment output after AD or SRAS shocks.’
In the AD-AS model, shocks can push real GDP away from full employment.
Two side-by-side AD–AS panels illustrate how macro shocks shift curves: a rightward shift of AD raises both the price level and real GDP in the short run, while a rightward shift of SRAS raises real GDP and lowers the price level. The vertical LRAS line marks full-employment output, making it easier to compare short-run deviations from potential output across different shocks. Source
Over time, market adjustments in wages and input prices shift short-run aggregate supply, moving the economy back toward potential output without new policy action.
What “self-adjustment” means in AD-AS
Self-adjustment is the long-run tendency for the economy to return to full-employment real GDP after a shock, as wages and other input prices become flexible and firms revise production decisions.
Self-adjustment: The process by which flexible wages and prices change over time to shift SRAS and restore real GDP to the full-employment level after an AD or SRAS shock, without government policy.
Self-adjustment is shown as a shift of SRAS, not a movement along SRAS. The key idea is that in the long run, nominal wages and other costs respond to labor-market conditions created by output gaps.
The core mechanism: wage and cost adjustment
When the economy is away from full employment, the labor market is typically either:
Weak (high unemployment), putting downward pressure on nominal wages, or
Tight (low unemployment), putting upward pressure on nominal wages.
Those wage changes alter firms’ per-unit production costs, which changes how much firms are willing to produce at each price level, shifting SRAS.
= Nominal wage rate (dollars per hour)
= Price level (index)
= Purchasing power of wages (real wage)
A falling (or slower wage growth) reduces costs for firms relative to output prices, supporting a rightward SRAS shift; a rising raises costs, supporting a leftward SRAS shift.
Self-adjustment after an AD shock
Negative AD shock (AD shifts left)
A decrease in aggregate demand reduces real GDP and price level in the short run, creating a recessionary situation with idle resources. Over time:
Unemployment rises, weakening workers’ bargaining power.
Nominal wages and other input prices fall (or grow more slowly).
Firms’ costs decrease, so SRAS shifts right.
Real GDP rises back toward full-employment output; the price level tends to fall further or stabilise at a lower level, depending on the adjustment path.
Positive AD shock (AD shifts right)
A surge in aggregate demand raises real GDP and price level in the short run, creating an overheating economy. Over time:
Unemployment falls, tightening labor markets.
Nominal wages and input prices rise.
Higher costs reduce SRAS, so SRAS shifts left.
Real GDP falls back toward full-employment output; the price level tends to rise further or stabilise at a higher level.
Self-adjustment after an SRAS shock
A supply shock directly shifts SRAS and changes both output and the price level in the short run. Self-adjustment still works through wage and cost flexibility:
After a negative SRAS shock (costs rise), short-run output is lower. Over time, weaker labor-market conditions can restrain wage growth, easing cost pressures and shifting SRAS back right.
After a positive SRAS shock (costs fall), short-run output is higher. Over time, tighter labor markets can push wages up, shifting SRAS back left.
Why the return to full employment can take time
Self-adjustment is a long-run story because wage and price flexibility is imperfect in practice:
Long-term contracts and implicit agreements slow wage changes.
Menu costs and coordination problems slow price changes.
Firms may delay wage cuts due to morale and turnover concerns, making downward wage adjustment especially slow.
FAQ
Downward wage rigidity is common.
Firms resist wage cuts to avoid lower productivity and higher quits.
Contracts lock in wages, so adjustment happens when contracts renew.
If firms expect weak demand to persist, they may delay hiring and investment even as wages soften.
That can slow the cost-based SRAS shift back towards full employment.
It can be disrupted.
Rapid changes in participation, skills, or matching efficiency can alter what “full employment” looks like, complicating the return to the previous potential output level.
If output prices adjust slowly while wages move, firms’ mark-ups change.
That can temporarily compress profits and delay production responses, slowing the SRAS shift.
Not necessarily.
Full employment can be restored with stable inflation if nominal wages grow more slowly than productivity, lowering unit labour costs even when the overall price level does not fall.
Practice Questions
(2 marks) Explain how the economy can return to full-employment output after a negative aggregate demand shock without government intervention.
Identifies that wages/input prices fall or wage growth slows as unemployment rises (1).
Explains that lower costs shift SRAS right, restoring real GDP to full-employment output (1).
(6 marks) Using the AD-AS model, explain the long-run self-adjustment process following a positive aggregate demand shock. Refer to changes in wages/costs, SRAS, real output, and the price level.
States short-run effect: AD increases causing real GDP and price level to rise (1).
Links higher output to lower unemployment/tighter labour market (1).
Explains nominal wages and input costs rise over time (1).
States SRAS shifts left due to higher costs (1).
Explains real GDP returns to full-employment output (1).
States price level rises further or remains higher in the long run than initially (1).
