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chapter 24

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University of Toronto St. George
Michael Ho

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 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 capitalare 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 theyre 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. Output below potential Y
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