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02.27 - Endogenous Factor Price Adjustments

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ECON 102
Lanny Zrill

Endogenous Factors: Price Adjustments 02-27-2013 Time Frames in Economics Defined not by length of time, but rather according to which variables are assumed to change.  Short run  Factor Price Adjustment Period  Long Run Short Run Assumptions  Factor prices are exogenous ex. fixed  Technology and Factor Supplies are constant – affects Y* o PPB is fixed; therefore, Potential Output is also constant  Exogenous shocks to supply and demand cause fluctuation around Y* In the short run, equilibrium, is determined by the intersection of the AS and AD curves Factor Price Adjustment Assumptions  Factor prices are flexible and adjust to output gaps  Technology and factor supplies are constant Long run equilibrium occurs when AS = AD and factor prices are fully adjusted Long Run Assumptions  Factor prices have fully adjusted to output gaps o Therefore, there are no more output gaps (eliminated) o Real GDP = Potential level  Technology and Factor Supplies are changing Output Gaps and Factor Prices Recessionary Gap  Short run equilibrium – where two curves cross  But Y0 < Y*  recessionary gap  Relationship between recessionary gap and intensity of resource use: some resources are sitting idle that can possibly be productive o Firms producing below potential output o Demand for factors of production is low  If the demand for a commodity decreases, the demand for the factors of that commodity decreases as well.  As the factor prices fall, AS curve shifts to the right  Real GDP returns to its Potential Level (Y*) Summary: 1. In a recessionary gap, resources are underutilized  some factors are idle 2. There is an over-supply of factors 3. This puts downward pressure on factor prices 4. Which decreases unit costs for firms 5. AS increases and shifts to the right Exam question: Explain the factor price adjustment process in a recessionary gap.  Points 1,3,4,5 – Complete answer Inflationary Gap  Real GDP is above Potential GDP  Resources are being over-utilized – firms are demanding more resources than people want to supply (ex. everyone working 45 hours a week)  Excess demand for factors (labour)  upward pressure on price of wage  AS falls Summary: 1. In an inflationary gap, resources are over-utilized – factors of production are over-used 2. Therefore, there is an under-supply of factors 3. This puts upward pressure on factor prices 4. Which increases unit costs for firms 5. So, AS decreases – shifts to the left Exam question: Explain the factor price adjustment process in an inflationary gap. Wage Adjustment Asymmetry Will wages adjust at the same rate for either type of gap? No.  Wage contracts or unions may make it difficult to lower wages  Also, lowering wages may lead to disgruntled employees  But who would say no to an increase in their wages? Thus, we would expect a slower adjustment to recessionary gaps.  Firms are reluctant to make everyone upset at them  will underperform at work  Hard to deal with some contracts/unions Do wages really fall during recessionary gap?  If you’re trying to cut wage costs by 10%, better to fire 10% of people rather than cut everyone’s salary by 10%.  Thus, people’s wages don’t go down; people just get fired.  This held true only until the 2008 Financial Crisis. Testing the Theory Our theory of endogenous factor price adjustments implies the following:  Recessionary gap  falling wages  Inflationary gap  rising wages How can we test this? The Phillips Curve  Describes the relationship between the rate of change of wages and the unemployment rate o When there is a recessionary gap, there is greater unemployment than the natural rate o Recessionary gap  high unemployment  falling wages  At 0 – wages constant. (-) – wages are falling. (+) – wages are rising.  Negative relationship with rate of change of wage and the unemployment rate Long Run Consequences to Economic Shocks 03-01-2013 Aggregate Demand Shocks What is the long-run impact of a shock to aggregate demand? Assume that the economy begins where national income = potential output.  Consider a rise in interest rate  How does this affect national income and the price level in the short run? o Decrease consumption (arises from the fact that if the interest rate goes up, people will want to save) o Reduction in investment because cost of borrowing money is higher o First equilibrium: AD0 & AS0  New Equilibrium: AD1 & AS0  Decrease in the price level and recessionary gap (Y > Y*)  What about in the long run? o AD1 & AS1 o Recessionary gap goes away because of adjustment of prices o BUT there will still be a lower price level o Changes in aggregate demand will only result in changes in the price level Summary:  Higher interest rate  decrease in aggregate demand o AD curve shifts left – lower Y and P  Recessionary Gap  under-utilization/over-supply of resources o Decrease in factor prices and unit costs o AS curve shifts right o Y = Y* and P is lower  Long-run impact of shock is a lower price level Aggregate Supply Shock What is the long-run impact of a shock to aggregate supply? Assume the economy begins where Y = Y*.  Consider an increase in the price of oil.  Effects in the short run? o Increase in price in oil  decrease in GDP  recessionary gap  decrease in the price level  Effects in the long run? o Allow factor prices to adjust (long run definition) o Rightward shift of AS curve: AS1  AS2 o Real GDP is going to return to its potential level o Price of factor (oil) will fall after this adjustment o Criticism of the model: Aggregate supply shocks have no effect – not true! Summary:  Higher price of oil  decrease in aggregate supply  AS-curve shifts left – lower Y and higher P  Recessionary gap  under-utilization/over-supply of resources o Decrease in factor prices and unit costs o AS curve shifts right  Long run impact of shock is no change price level or national income  However, other factor prices (including wages) are now lower as a result Long Run Supply Curve  In the LR, the level of Real GDP is constant and equal to Y*  Only the price level changes & is determined by Aggregate Demand  We can define the Long Run Supply Curve as a vertical line equal to Y* o The quantity
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