Long-Run Self-Adjustment

Markets clear, even slow ones. In a recessionary gap, output sits below potential and unemployment is high. Workers have weak bargaining power, so nominal wages drift down over time. Lower wages cut firms' production costs, so at every price level firms are willing to supply more. SRAS shifts right. The economy slides down along aggregate demand, the price level falls, and output rises back toward potential. Nobody planned this. It happens because a slack labor market slowly pushes wages toward what firms can actually afford to pay.

An inflationary gap runs the same logic in reverse. Output sits above potential, the labor market is tight, and workers can demand higher pay. Rising nominal wages raise firms' costs, so SRAS shifts left. Output falls back down toward potential, but the price level keeps climbing as it does. Either way, the economy ends up back at potential output, right where the LRAS curve sits, because LRAS reflects what the economy can produce once wages and prices have fully adjusted.

This does not make fiscal or monetary policy pointless. Self-correction works only through slow wage adjustment, and wages are sticky, especially downward. A recession could take years to fix itself, with real unemployment and lost output the whole time. Active policy shifts aggregate demand directly, closing the gap faster and cutting that cost. Self-adjustment explains where the economy ends up in the long run; policy is about how much it costs to get there and how long the trip takes.