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Lecture

ECO102H1 Lecture Notes - Nominal Rigidity, Potential Output, Output Gap


Department
Economics
Course Code
ECO102H1
Professor
Michael Ho

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Chapter 24 from the short-run to the long-run
The short-run
These are the defining characteristics of the short-run in HR macroeconomic model:
1. Factor prices are assumed to be exogenous; they may change but any not explained within the
model, but any change
2. Technology and factor supplies are assumed to be constant (and therefore Y* is constant).
The level of real GDP fluctuates around a constant level of potential output, Y*. This version of
our macroeconomic model is convenient to use when analyzing the economy over short
periods. Even though factor prices, technology and factor supplies are rarely constant, event
over short periods of time. The simplifying assumption that they are constant in our short run
model allows us to focus on the most important changes over this time span: the fluctuations of
real GDP relative to the level of potential output, what economists call business cycles.
The adjustment of factor prices
Our theory of the adjustment process that takes the economy from the short-run to the long-
run is based on following assumptions:
1. Factor prices are assumed to adjust in response to output gaps.
2. Technology and factor supplies are assumed to be constant (and therefore Y* is constant).
Note to that, as in the short run version of the model, the adjustment process is assumed to
take place with a constant level of potential output.
Our theory of macroeconomic adjustment process is useful to examining how the effects of
shocks or policies defer in the short run and long runs. As we will see, the assumption that
potential output is constant leads to the prediction that AD and AS shocks have no long-run
effect on real GDP; output eventually returns to Y*.
The long-run
These are defining characteristics of the long-run in our micro model:
1. Factor prices are assumed to have fully adjusted in any output gap
2. Technology and factor supplies are assumed to be changing.
After factor prices have fully adjusted real GDP will return to the level of potential output. The
second assumption implies that the level of potential output is changing ( are typically growing).
Therefore, in the long-run version of the macroeconomic model, our focus is not on the major of
business cycles but rather on the nature of the economic growthwhere technological change
and the role of factor supplies play key roles.
Summary

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24.1 the adjustment process
Potential output and the output gap
Potential output is the total output that can be produced when all productive resources such as
land, labor, and capital—are being used at their normal rates of utilization. When in nations’
actual output diverges from its potential output, the difference is called the output gap.
In this chapter review variations in the output that as determined solely by variation in actual
GDP around a constant level of potential GDP.
Factor prices and the output gap
When real GDP is above potential output, there will be pressure on factor prices to rise because
of a higher than normal demand or factor inputs.
When real GDP is below potential output, there will be pressure on factor prices to fall because
of their lower than normal demand for factors inputs
These relationships are assumed to hold for the prices of all factors of production, including
labor, land, and capital equipments.
Output above potential Y> Y*
Sometimes AD and AS curves intersects where real GDP exceed potential. Because firms are
producing beyond their normal capacity output, there is an unusually large demand for all factor
inputs, including labor. Labour shortage will emerge in some industries and among many groups
of workers. Firms were trying to bait workers away from other firms in order to maintain the
high levels of output and sales made possible by the boom conditions.
As a result of this tight labor market conditions, workers will find that they’re have considerable
bargaining power with their employers, of and they will put upward pressure on wages. Firms
are recognizing that demand for their curves is strong will be anxious to maintain a high level of
output. To prevent their workers for and a striking are quitting and moving to other employers,
firms will be willing to accede to some of this upward pressures.
The boom that is associated with an inflationary gap generates a set of conditionshigh
profits for firms and unusually large demand for laborthat tends to cause wages (and other
factors prices) to rise.
This increase in factor prices will increase firms’ unit costs. As unit costs increase firms will
require higher prices in order to supply of any given level of output, and the AS curve will
therefore shift up. This shift has the effect of reducing equilibrium of real GDP and rising price
level. Real GDP moves back toward potential and the inflationary gap begins to close.

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Output below potential Y<Y*:
Sometimes the AD and AS curves intersect is less than the potential output. Because firms are
producing below their normal capacity output, there is an unusually low demand for all factors
inputs, including labor. There will be labour surpluses in some industries and among some
groups of workers. Firms will have below normal sales and in not only will resist output
pressures on wages on some may seek reduction in wages.
The slump that is associated with a recessionary gap to generate a set of conditions, low
profits for firms and lower demand for laborthat tends to cause wages and other factors
prices to fall.
When it occurs in this reduction in factors prices will reduce firms’ unit costs. As unit costs falls,
firms required in lower price in order to supply any given level of output, and the AS curve
therefore shuts down. This shift has the effect of increasing equilibrium real GDP and reducing
the price level. Real GDP moves back toward potential and the recessionary gap begins to close.
Downward wage stickiness
Boom conditions (an inflationary gap) that along with labour shortage, cause wages and unit
costs to rise. Downward pressures of wages during slumps (recessionary gap) often do not
operate at strong record as quickly as the upward pressure during booms.
Even though when wages do fall, they eat and fall more slowly than they would arise in an
equally sized inflationary gap. This downward wage stickiness implies that the downward shift
in the AS curve and a downward pressure on the price level are correspondingly slight.
Both upward and downward adjustment to wages and unit costs do occur, but there are
differences in the speed at which they typically operate. Boom can cause wages to rise
rapidly; recessions usually cause wages to fall only slowly.
The Phillips curve:
Phillip observed that wages tend to fall in periods of high unemployment and rise in periods of
low unemployment. The resulting negative relationship between unemployment and the rate of
change in wages has been called its relationship to the aggregate supply (AS) curve.
Inflationary and recessionary gaps:
When real GDP exceeds potential GDP, there will normally be raising unit costs and the AS curve
will be shifting upward. This will in turn push the price level up and create temporary inflation.
The larger the excess of real GDP over potential GDP, the greater the inflationary pressure. The
term inflationary gap emphasizes this salient feature of the economy when Y>Y*
When actual output is less than potential output, of there will be unemployment of labour and
other productive resources. Unit costs will tend to fall slowly, leading to a low downward shift in
the AS curve. Hence, the price level will be falling only slowly so that recessionary gap
emphasizes this salient feature that high rates on unemployment occur when Y<Y*.
Potential output as an “anchor”
Following an aggregate demand or supply shock, the short run equilibrium level of output
may be different from potential output. Any output gap us assumed to cause wages and other
factors prices to adjust, eventually bringing the equilibrium level of output back to potential.
In this model, therefore, the level of potential output acts line an “anchor” for the economy.
Phillips curve: originally, a relationship between the unemployment rate and the rate of change
of money wages. Now often drawn as a relationship between GDP and the rate of change of
money wages.
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