The Long-Run Self-Adjustment From a Negative Output Gap

Economic systems generally aim for a state of balance, where resources are fully utilized to produce goods and services. However, economies do not always operate at this ideal level, often experiencing periods where their actual output deviates from their potential. This difference is commonly referred to as an “output gap,” indicating whether an economy is producing more or less than its sustainable capacity. This article will explore how, in the long run, an economy naturally moves back towards its full potential when it is operating below it, a process known as self-adjustment.

Understanding a Negative Output Gap

A negative output gap occurs when an economy’s actual output falls below its potential output. Potential output represents the maximum sustainable level of goods and services an economy can produce when all its resources, such as labor, capital, and technology, are fully and efficiently employed without generating inflationary pressures. In contrast, actual output is the current level of goods and services being produced at any given time.

This situation leads to underutilized resources across the economy. For instance, a negative output gap is often associated with higher unemployment rates, meaning a portion of the available workforce is not engaged in production. Similarly, factories might operate below their full capacity, with machinery lying idle and production lines running at reduced speeds. This underutilization can result from various factors, including a decrease in consumer spending or business investment.

Market Mechanisms Driving Adjustment

The inherent ability of an economy to self-correct from a negative output gap is largely driven by fundamental market forces, particularly wage and price flexibility. When an economy experiences a negative output gap, it means there is an excess supply of labor and goods. This surplus creates downward pressure on both wages and prices, which are the primary mechanisms for adjustment.

In a situation characterized by high unemployment, workers find themselves competing for a limited number of available jobs. This increased competition among job seekers leads to a deceleration in wage growth, as businesses face less pressure to offer higher compensation. Similarly, when there is excess production capacity and reduced consumer demand, businesses compete more intensely for customers. This intensified competition results in downward pressure on the prices of goods and services, as companies attempt to attract buyers.

These changes in wages and prices directly influence the economy’s aggregate supply. Specifically, lower wages reduce the costs of production for businesses. When production costs decrease, businesses are willing and able to supply more goods and services at any given price level. This shift in production willingness and ability is represented by a rightward movement of the Short-Run Aggregate Supply (SRAS) curve.

The Self-Correction Process

The self-correction process begins with the initial state of a negative output gap, where actual economic output is significantly below its potential, leading to elevated unemployment levels. In this environment, the abundance of available labor creates substantial downward pressure on wages.

Lower wages translate directly into reduced production costs for businesses. This decrease in the cost of inputs allows businesses to lower the prices of their products, making them more affordable for consumers. The general decline in the price level encourages greater purchasing activity throughout the economy.

Falling prices can stimulate aggregate demand through several channels. For example, lower prices increase the real purchasing power of existing money balances, making consumers feel wealthier and more inclined to spend. Additionally, reduced demand for money due to lower prices can lead to a decrease in nominal interest rates, which encourages borrowing and investment. Furthermore, lower domestic prices can make a country’s goods more competitive in international markets, potentially boosting exports.

Crucially, the decrease in production costs, driven by lower wages and prices, causes the Short-Run Aggregate Supply (SRAS) curve to shift to the right. This rightward shift indicates that, at every price level, firms are now willing and able to supply a greater quantity of goods and services. As the SRAS curve shifts outward, it gradually brings actual output back towards the economy’s long-run potential output. This adjustment process continues until the economy reaches a new equilibrium where resources are fully employed, and unemployment returns to its natural rate.