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Chapter 24.docx

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Marilyn Cottrell

Chapter 24: Output and Prices in the Long Run The Long Run GDP and prices adjust to reach equilibrium in the long run  Assume technology constant  Factor prices now change  Begin with long run equilibrium- GDP at potential: Potential GDP or output  All productive resources (factors of production) used at their normal rates of utilization No Output Gap  Vertical line at equilibrium is Y*  No output gap  GDP is at potential (Y*)  Price level is Po  GDP at Y* When Y=Y*  Unemployment Rate equals the natural rate of unemployment U*  U* includes both structural and frictional unemployment Output Gaps  If actual output is below potential, have recessionary output gap Y less than Y*  If actual output is above potential, have an inflationary output gap Y greater than Y* Inflationary Output gap When Y greater than Y*:  Demand for labour (and other factor services) is high Boom leads to:  High profits for firms  High demand for labour  Wages and production costs rise  Higher production costs shift AS leftward  Prices rise  Output declines- equilibrium falls to Y* A recessionary output gap When Y less than Y*:  Demand for labour (and other factor services) is low Slump leads to:  Low profits for firms  Low demand for labour  Wages and unit production costs fall  AS curve shifts rightward  Output rises  Prices fall  Equilibrium GDP rises to Y* Speed of factor-price adjustment  Factor-prices adjust at different speeds  Booms cause wages to rise rapidly  Slumps cause wages to fall slowly In long run, potential output is an anchor:  Shock raises short run GDP above or below Y*  Wages and other factor prices adjust  GDP returns to Y* Aggregate Demand and Supply Shocks Long Run-Positive AD Shock Self-adjustment mechanism  Return economy to potential GDP  i.e., it removes unemployment, if wage rates fall ``Wage rates `sticky in a downwards direction`` (Keynes)  if wages fall slowly, or not at all  supply curve may not shift rightward  U may not return to U* (natural rate of unemployment) at Y* (full employment) until demand rises After AD or AS shock  Wage flexibility determines speed economy returns to Y* Flexible wages:  Rapidly during inflationary output gaps  Provide an automatic adjustment mechanism  Pushes economy back to potential Sticky or rigid wages:  Economy is adjustment mechanism is sluggish  Output gaps tend to persist Economic Shocks and Business Cycles  AD and AS subject to continual random shocks  Automatic adjustment mechanism converts shocks into cyclical fluctuations in real GDP  Lags cause changes in output to be extended over long periods of time Long-Run Equilibrium  Excess demand or supply of labour (and other factors) will be eliminated  Full employment of factors  Output at potential level, Y*  Potential GDP is vertical at Y*  There is no relationship in long run between price level and output produced  Unemployment is U*  Firms’ output same, regardless of price level Potential GDP may increase over time:  Change in productivity or,  Change in technology  Economics growth  Y* s
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