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Chapter 24

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ECON 102
Ying Kong

Short Run to Long Run: The Adjustment of Factor Prices 3/6/2013 8:16:00 PM The Short Run Defining characteristics of the short-run macroeconomic model  Factor prices are exogenous (changes not explain in the model)  Technology and factor supplies are assumed to be constant (Y* is then constant) - equilibrium occurs at the intersection of AD & AS curve - level of real GDP fluctuates around constant level of potential output (Y*) AKA the business cycle  fluctuations of the real GDP relative to the level of potential output Adjustment of Factor Prices The theory of the adjustment processes that take the economy from short to long run are based off the assumptions that:  Factor prices are assumed to adjust in response to output gaps  Technology and factor supplies are assumed to be constant - deviations of real GDP from potential output cause wages and other factor prices to adjust  essential to shift from short to long run - the adjustment processes examines how shocks and policy effects differ in the short and long run - AD and AS shocks have no long-run effect on GDP  output eventually returns to Y* The Long Run Defining characteristics of the long-run in the macro model:  Factor prices are assumed to have adjusted to any macro model  Technology and factor supplies are assumed to be changing - after factor prices have adjusted, real GDP will return to the level of output - the level of output is typically changing/growing - the economy is probably never “in” the long run in the sense that factor prices have fully adjusted to all AD/AS shocks  shocks are too continuous Summary SHORT RUN THE LONG RUN ADJUSTMENT PROCESS ASSUMPTION Factor prices are Factor prices are Factor prices are S exogenous flexible/endogeno fully us adjusted/endogeno Technology and us factor supplies Technology and (and  Y*) are factor supplies Technology and constant/exogeno (and  Y*) are factor supplies (and us constant/exogeno  Y*) are us changing/ endogenous CHANGES IN AD/AS shocks Following AD/AS Changes in Y* REAL GDP cause Y to shocks, Y determine changes fluctuate around a eventually returns in Y constant Y* to Y* WHY WE Allows for analysis Allows for analysisAllows for analysis STUDY THIS of the fluctuations of the adjustment of the nature of STATE of Y around Y* processes from economic growth the short-run why Y* increases equilibrium to the over long periods of long-run time equilibrium THE ADJUSTMENT PROCESS Potential Output and the Output Gap - when a nation’s actual output diverges from its potential output, the difference is called the output gap - output gap are variations in actual GDP around variations in potential GDP - potential output is assumed to be constant Factor Prices and the Output Gap ASSUMPTIONS:  When real GDP is ABOVE potential output, there will be upward pressure on factor prices b/c of high demand for factor inputs  When real GDP is BELOW potential output, there will be downward pressure on factor prices b/c of low demand for factor inputs - Note: even when there is no output gap, the presence of ongoing inflation influences factor prices, especially wages Output Above Potential Y>Y* - Because firms are producing more than normal capacity, there is a large demand for factor inputs, inc labour - firms will try to steal workers from other firms to maintain the output demand of the boom - when workers know this they demand higher wages  to prevent workers from quitting or striking, firms will accommodate  wages/ unit costs will rise - as unit costs rise, firms will have to increase prices for given output level  AS curve shifts up  increase unit costs/prices = increase AS curve = decrease output gap ** the boom that is associated with an inflationary gap generates a set of conditions (high profits and large labour demand) that will cause wages to rise** Output Below Potential Y potential GDP = increase unit costs = increase prices = inflation  Y>Y* - the greater the gap between Y and Y*, the greater the inflationary pressure RECESSIONARY - real GDP < potential GDP = decrease unit costs = decrease prices = recession  YY* - inflationary gap results in increase wages, etc  unit cost rise  AS curve shifts up/left  AS to0AS 1  Increase AS = further rise in price level  Inflationary gap closed  back at Y* ** The adjustment in wages an other factor prices eventually eliminates any boom caused by demand shock; real GDP returns to its potential** Contractionary AD Shocks - negative AD shock (decrease in aggregate demand  decline exports etc.)  AD shifts down from AD to 0D 1  Prices decrease  Opens a recessionary gap  Y
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