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Chapter 24

Chapter 24 Notes

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ECON 110
Ian James Cromb

Chapter 24 Notes  Adjustment process from a short to long run model assumes instead that factor prices are flexible and adjust to output gaps, and technology and factor supplies are constant (Y* constant)  In long run factor prices and technology change  Focus on economic growth 24.1 The Adjustment Process Potential Output and the Output Gap  Potential Output is total output that can be produced when resources are at normal rate of utilization  Recessionary gap when intersection between AS and AD (equilibrium) is less than potential output, inflationary when it’s greater than potential output Factor Prices and the Output Gap  When real GDP is above potential output, demand for factors will be high and prices will rise  Rise in factor prices will increase unit costs, and firms will have to sell at higher prices in order to cover costs at a given output, so AS shifts up. This starts to close inflationary gap  Economic booms cause wages to rise rapidly, but recessions cause wages to fall slowly -> wage stickiness  Philips Curve: relationship between GDP and the rate of change of money wages  Wage changes and unemployment downward sloping (negatively correlated) while wage changes and output are upward sloping (positively correlated)  Inflationary gap shifts AS up faster than recessionary gap shifts AS down Potential Output as an Anchor  After aggregate demand/supply shocks, short-term equilibrium differs from potential output until factor price and wage changes bring it back to potential 24.2 – Demand and Supply Shocks Expansionary AD Shocks  Boom -> increase in autonomous expenditure -> AD curve shifts up -> increased price and GDP -> inflationary gap  Inflationary gap leads to increase in wages, unit costs higher  Higher input costs shift AD curve up -> price rises, GDP lowers -> inflationary gap closes Contractionary AD Shocks  Fall in output -> downward adjustment of prices and GDP -> recessionary gap -> unemployment rises  When wages fall quickly, recessionary gap quickly eliminated  When wages are downwardly sticky, recessionary gap remains open for a prolonged period  Quick recovery rests on the demand side, raises possibility for government stabilization policy to accomplish this Aggregate Supply Shocks  Increased input price -> AS shifts up -> GDP falls and prices increase (called stagflation) -> recessionary gap -> firms shut down, workers laid off (excess supply) -> wages decrease (slowly) -> gap closes Long-Run Equilibrium  When factor prices are no longer adjusting to output gaps, economy is in long-run equilibrium  Long-run output is independent of price levels  Vertical Y* = long-run aggregate supply curve or classical aggregate supply curve  In long-run, GDP determined by Y*, AD only determines price level 24.3 – Fiscal Stabilization Policy The Basic Theory of Fiscal Stabilization  Reduced tax + increased government purchases = rightward shift in AD  Recessionary gap may be closed by: o Slow decrease of prices, AS shifts down o Demand recovers, AD shifts right o Government uses expansionary fiscal policy to shift AD right (receded tax, increased spending)  Policy shortens recessionary gap, but may create inflationary gap  Increased individual savings of everyone at the same time would reduce short-run GDP, called the paradox of thrift: what may be good for an individual may be bad for the economy  Paradox of thrift applies only in the short-run, when AD plays an important role in determining GDP  Increased savings in the long-run, when investment and potential output  Discretionary fiscal policies are active attempts by government to improve economy  Automatic Stabilizers change the economy through government’s mere existence  Automatic Stabilizers: elements of the tax-and-transfer system that reduce responsiveness GDP to changes in autonomous expenditure  Tax dampens the effect a rise in national income on spending (decreases the multiplier)  Reductions in tax rates lead to a less stable economy Practical Limitations of Fiscal Policy  Decision Lag: period of time between perceiving some problem and reaching a decision on what to do about it  Execution Lag: time it takes to put policies in place after a decision has been made  Tax changes that are known to be temporary have l
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