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.