How does an economy that is experiencing an expansionary gap adjust in the long run?
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In the long run, an economy that is experiencing an expansionary gap (also called an inflationary gap) adjusts automatically through the price mechanism.
When an economy is experiencing an expansionary gap, it is producing more than it is capable of producing in the long term. This means that it is, in essence, over-using its resources. Typically, what this means is that it is requiring workers to work longer hours and it is hiring workers who are less qualified simply to have “warm bodies” to fill jobs. When this happens, the costs to employers rise. They have to pay more in overtime. They have to pay good wages to workers (the new, less qualified workers) who are not actually able to be productive enough to justify these wages. This makes the cost per unit of production increase.
When these costs increase, firms must raise the prices that they charge consumers. When the price level rises, aggregate demand falls. When aggregate demand falls, the economy returns to equilibrium at its potential output level.
In the long run, this economy may also respond by increasing aggregate supply and thus creating a new, higher level of potential production. Firms may innovate and find ways to meet the higher demand without raising costs. Thus, the economy will adjust first by lowering aggregate demand through higher prices and eventually (if all goes well) by increasing aggregate supply.
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