Principles of Macroeconomics / Unit 10 MAC 0905 worked example, 60 to 90 seconds
Working the Self-Correction Sequence
The idea
Trace a demand shift through both curves until the economy is back at potential. The sequence is always the same four steps: demand shifts, the short run lands off potential, the labour market responds, and short-run supply shifts until potential is restored. Unit eight named this sequence; here it is worked in both directions.
In practice
Take potential GDP of 7,000 billion. Aggregate demand shifts right. In the short run output rises above 7,000 and unemployment falls below the natural rate. Employers now compete for scarce workers, so nominal wages rise, which is an input price increase, so short-run supply shifts left. Output returns to 7,000 at a higher price level. Now run it the other way. Demand shifts left, output falls below 7,000, unemployment rises above the natural rate. Wage growth stalls or reverses, short-run supply shifts right, and output returns to 7,000 at a lower price level.
Where people slip
Both directions end at the same output and differ only in the price level, which is the whole neoclassical claim. Note what the sequence does not say: it gives no date. How long the middle steps take is the disputed question, and the next three entries are about that dispute rather than about the mechanism.
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