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Chapter 24

Economics Chapter 24 Summary.docx

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Economics (Arts)
ECON 209
Mayssun El- Attar Vilalta

Economics Chapter 24 Summary The Short Run - Short run equilibrium is determined by intersection of AD AS curves - Short run is for business cycles The Adjustment of Factor Price - Factor price adjusts in response to output gaps - Technology and factor supplies are constant therefore Y* is constant The Long Run - Factor prices have fully adjusted to any output gap - Technology and factor supplies are changing - Focussed on nature of economic growth 24.1 The Adjustment Process Potential output and Output Gap - Diverging from potential output forms an output gap - If Y < Y* = recessionary gap, downward pressure on prices - If Y > Y *= inflationary gap, upward pressure on prices Factor Prices and Output Gap Output above Potential: Y > Y* - So producing more than normal amount thus creating unusually large demand for factor inputs (shortages occur) so they raise how much they are willing to pay for factors of production - Boom associated w/ inflationary gap generates a set of conditions—high profits for firms and unusually large demand for labour—tend to cause wages and other factor prices to rise - Increase in factor prices increases firms’ unit cost so supply shifts left and reduces equilibrium real GDP and raises price level; real GDP moves towards potential and inflationary gap starts closing - Prices continue to rise until AS curves shifts to point where equilibrium level of Y= Y* Output below Potential: Y< Y* - Producing below normal capacity so unusually low demand for factor inputs including labour - Slump is associated w/ recessionary gap generates a set of conditions—low profits for firms and low demand for labour—tends to cause wages and other factor prices to fall - Reducing in factor prices=firms’ unit costs to fall. AS curve shifts right & increases equilibrium real GDP & reduces price level; moving real GDP toward Y* closing recessionary gap Downward Wage Stickiness - Boom causes wages to rise but downward pressure on wage doesn’t occur as quickly as booms - Implies downward shift in AS curve and downward pressure on price is less than upward pressures - Both up and downward adjustment to wages an unit cost occur but at different speeds The Philips Curve - Wages fall in periods of high unemployment and rise in periods of low unemployment - Results in negative relationship between unemployment and rate of change in wages Inflationary and Recessionary Gaps - High rates of unemployment occur at recessionary gaps - Inflation mostly occurs in inflationary gaps Potential Output as an Anchor - Following AD or AS shock, short-run equilibrium level of output may be different from potential output. Ay output gap is assumed to cause wages and other factor prices to adjust eventually bringing equilibrium level of output back to potential. Therefore level of potential output acts as an anchor for the economy The Philips Curve and the Adjustment Process - Relates how fast wage changes to level of unemployment—negatively related - A recessionary gap= high unemployment - Inflationary gap= low unemployment - When output equals Y* the natural rate of unemployment is U* - When Y >Y*, U U* in recessionary gaps - Wage changes against real GDP is upward sloping so as GDP increases, wages increase and as GDP falls, wages fall 24.3 AD and AS Shocks Expansionary AD Shocks - If there is an expansionary AD shock, AD shifts outward which causes prices to go up which causes unit costs to be more expensive so companies raise their prices and shift AS upwards which brings it back to potential output but now at a higher level of prices Contractionary AD Shocks - If there is decline in AD, negative AD shock causes downward pressure on prices which creates recessionary gap where unemployment rises.2 cases: 1.) wages fall quickly in response to excess supply of labour 2.) Wages fall only slowly - Flexible Wages: if they fell quickly, AS curve would shift quickly down and lower wages led to reduced unit cost. Economy move along new AD curve w/ falling prices & rising output until real GDP was restored to Y*; if wages fall resulting shift in AS curve would quickly eliminate gaps - Flexible wages fall rapidly in presence of recessionary gap which provide automatic adjustment process that pushes economy back quickly towards Y* - Sticky Wages: same as before but AS curve shifts more slowly and may not be removed by adjustment process; recessionary gap closes as a result of eventual expansion in AD AS Supply Shocks - Stagflation: real GDP falls and price level increases due to negative AS shock - Recessionary gap causes firms to shut down, workers laid off which causes excess supply of labour and eventually pushes wage down causing AS to shift back towards starting point; economy returns to initial point however relative prices have changed b/c real wages are lower due to the fact that other things are relatively more expensive - Positive AS shock leads to AS curve shifting down; more people hired, inflationary period, increase in wages, unit price goes up so they shift AS back up so that it decreases price once more to its original level - Exogenous changes in input price cause AS curve to shift, creating output gap. Adjustment process reverses initial AS shift & brings economy back to potential output and initial price level Long-Run Equilibrium - Long-run equilibrium when factor prices are no longer adjusting to output gaps - Economy is in equilibrium when intersection of AD and AS occurs at Y* - No AS curve in long run as it is thought
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