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ECON 1P92.docx

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Brock University
Professor Cottrel

ECON 1P92 02/26/13 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) o All productive resources (factors of production) used at their normal rates of utilization When Y=Y*  Unemployment= natural rate (U*)  U* includes frictional and structural Output Gaps  Actual output below potential = recessionary output gap (YY*: o Demand for labor and other factor services is high o Boom leads to:  High profits for firms  High demand for labor  Wages and production costs rise o Higher production costs shift AS leftward (upward) o Prices rise o Output declines – equilibrium GDP falls to Y* Recessionary Output Gap  When Y*>Y: o Demand for labor and other factor services is low o Slump leads to:  Low profits  Low demand for labor  Wages and unit production costs fall o Lower production costs AS curve shifts rightward (downward) o Output rises o Prices fall o Equilibrium GDP rises to Y* ECON 1P92 02/26/13 Speed of Factor-Price Adjustment  Factor-prices adjust at different speeds  Booms cause wages to rise rapidly  Slumps cause wages to fall slowly  In the long run, potential output is an anchor: o Shock raises short run GDP above or below Y* o Wages and other factor prices adjust o GDP returns to Y* Long Run- Positive AD Shock  Short run until Potential is placed in Self- Adjustment Mechanism  Returns economy to potential GDP  i.e. it removes unemployment if wage rates fall  Wage rates ‘sticky in a downwards direction’ (Keynes) o If wages fall lowly or not at all o Supply curve may not shift rightward o U may not return to U*(natural rate of unemployment) at Y*(full employment) until demand rises After D 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’s 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 labor and other factors will be eliminated  Full employment of factors  Output at potential level, Y*  There is no relationship in long run between price level and output produced (multiple choice question) ECON 1P92 02/26/13  Unemployment is U*  Firms’ output same, regardless of price level Potential GDP May Increase Over Time:  Change in productivity or  Change in technology  Economic growth  Y* shifts rightward (downward)  Y* increases  Price level falls
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