Long run self adjustment | AP Macroeconomics | Khan Academy

What we have depicted here is an economy in long-run equilibrium. Notice the point at which the aggregate demand curve and the short-run aggregate supply curve intersect; that specifies an equilibrium price level (P₁) and an equilibrium level of output (Y₁). But notice that point of intersection; it also intersects the long-run aggregate supply curve, and so that is also our full employment output.

And just a reminder, full employment output does not mean that everyone in the economy is employed. It means that this is the level of employment that is sustainable. The level of full employment, if for some reason the unemployment rate were to get lower than that, would be an unsustainable situation for this economy. But what we really care about in this video is what happens if our aggregate demand curve shifts in the short run and in the long run.

So let's just imagine there's all sorts of positive news, and aggregate demand shifts up. So let's imagine—let me just shift our aggregate demand curve—so it shifts like that. So all of a sudden, everyone has become more optimistic, and at a given price level, they just want to demand more output. Well, what's going to happen in this universe? Well, in this universe, we have a new short-run equilibrium. So we are now right over there. Let's call this price level 2, and then this is output level 2, so Y₂ here.

And so what happened? Well, in the short run, we see that prices are going to go up. The suppliers of the output are going to say, "Hey, all these people want my output now. I'm going to charge more for it," and I'm also going to increase output. I was like, "Hey, there's a bonanza going on! People are not only wanting the demand anymore, but they're willing to pay for it more." And so our output actually goes beyond our full employment output.

And so you can imagine maybe unemployment goes below the sustainable rate; all sorts of people, instead of going to school or getting a job or whatever else, are coming out of retirement to work because there's just a bonanza going on. But what's going to happen in the long run? Well, in the long run, people who are working could say, "Gee, you know, my firm is having this bonanza. When my employment contract comes due, I'm going to ask for a raise."

And so as labor prices go up, what's going to happen to the short-run aggregate supply curve? Yes, it is going to shift up as well. And so let's make it shift well up as well. People are going to demand more and more and more and more and more and more money, all the way to the point that we get to our sustainable level of output again.

And so what really happened is, at first, we had this price inflation, and output increased beyond a sustainable level. Then people said, "Hey, no, I want more for my time." And so as wages went up, prices went up even further. And so we get back to—and if prices are going up even further, then even with the shifted aggregate demand curve, people are like, "Well, I might not want that much of it anymore." And then we shift back to this point right over here.

And so now if this was aggregate demand 2, after everyone got all optimistic, we will call this short-run aggregate supply 2, and our equilibrium price now is a good bit higher—price level 3—but we are back to our full employment output. So we could call this Y₃, which is the same thing as Y₁, which is equal to our full employment output.

And what you have just seen, this is known as the long-run self-adjustment mechanism. It's an argument that economists will sometimes make using this simplified model to say, "Hey, if you're in a situation that's either above your full employment output or below your full employment output, it's okay. It will, in the long run, self-adjust." Government might not have to intervene.

In future videos or in other videos, we'll talk about how a government might want to intervene in either direction. But this is an argument that's saying, "Well, look; in the short run, things might deviate from your full employment output, but in the long run, there are natural mechanisms that will allow output to get back to your natural potential, your full employment output."