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AGGREGATE SUPPLY: The total (or aggregate) real production of final goods and services available in the domestic economy at a range of price levels, during a given time period. Aggregate supply (AS) is one half of the aggregate market analysis; the other half is aggregate demand. Aggregate supply, relates the economy's price level, measured by the GDP price deflator, and aggregate domestic production, measured by real gross domestic product. The aggregate supply relation is generally separated into long-run aggregate supply, in which all prices and wages and flexible and all markets are in equilibrium, and short-run aggregate supply, in which some prices and wage are NOT flexible and some markets are NOT in equilibrium.
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                           SELF CORRECTION, INFLATIONARY GAP: The automatic process in which the aggregate market eliminates an inflationary gap created by a short-run equilibrium that is greater than full employment through increases in wages (and other resource prices). The self-correction mechanism is triggered by short-run resource market imbalances that are closed by long-run price flexibility. The self-correction process of the aggregate market also acts to close a recessionary gap with lower wages (and other resource prices). Self correction is seen as shifts of the short-run aggregate supply curve caused by changes in wages and other resource prices. The self-correction mechanism acts to close an inflationary gap with higher wages and a decrease in the short-run aggregate supply curve.With an inflationary gap, short-run equilibrium real production is greater than full-employment real production, meaning resource markets have shortages. In particular, labor is overemployed. Self correction is the process in which these temporary imbalances are eliminated through flexible prices as the aggregate market achieves long-run equilibrium. The key to this process is that changes in wages and other resource prices cause the short-run aggregate supply curve to shift. | Closing An Inflationary Gap |  |
The self-correction closure of an inflationary gap in the aggregate market can be illustrated using the exhibit to the right. The vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). This graph presents the two aggregate supply curves--long run and short run--but no aggregate demand curve. The vertical curve labeled LRAS is the long-run aggregate supply curve which marks full-employment real production. The positively-sloped curve labeled SRAS is then the short-run aggregate supply curve. The positioning of the aggregate demand curve and the point of intersection with the short-run aggregate supply curve indicates the inflationary gap. - Inflationary Gap: Click the [Inflationary Gap] button to reveal this output gap. With an inflationary gap, short-run equilibrium real production is greater than full-employment real production, meaning resource markets have shortages, and in particular labor is overemployed.
- Closing the Gap: In the long-run, this inflationary gap is closed with higher wages and a decrease in short-run aggregate supply. To illustrate this result, click the [Higher Wages] button. This button-clicking shifts the short-run aggregate supply curve to the left. A new equilibrium is achieved by the intersection of the new SRAS curve and the original AD curve. This intersection also coincides with the LRAS curve.
In the long run, wages and resource prices are flexible and they decline enough to eliminate imbalances in the resource markets. The result of rising wages (and other resource prices) is a boost in production cost. An increase in production cost causes a decrease in short-run aggregate supply, or a leftward shift of the SRAS curve.Note that the SRAS curve shifts leftward until it intersects BOTH the LRAS and AD curves at full-employment real production, which is long-run equilibrium. In particular, the new long-run equilibrium is at the full-employment level of real production. The SRAS curve absolutely MUST shift until this long-run equilibrium is reached. If the aggregate market does NOT reach long-run equilibrium, resource market imbalances persist, resource prices and production cost rise further, and the SRAS curve shifts more. However, once long-run equilibrium is reached, resource market imbalances are eliminated, resource prices and production cost do not change, and the SRAS curve does not shift any further.
Recommended Citation:SELF CORRECTION, INFLATIONARY GAP, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2025. [Accessed: April 3, 2025].
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