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Chapter 24

Chapter 24- The Adjustment of Factor Prices.doc.docx

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Department
Economics
Course
ECO100Y5
Professor
Kalina Staub
Semester
Fall

Description
Chapter 24- From the Short Run to the Long Run: The Adjustment of Factor Prices The Short Run • Key assumptions:  Factor prices are exogenous; they may change but any change is not explained  Technology and factor supplies (and thus Y*) are constant/exogenous • What happens: Real GDP (Y) is determined by aggregate demand and aggregate supply • Why we study this state: To show the effects of AD and AS shocks on real GDP The Adjustment of Factor Prices • Key assumptions:  Factor prices are flexible/endogenous  Technology and factor supplies (and thus Y*) are constant/exogenous • What happens: Factor prices adjust to output gaps; real GDP eventually returns to Y* • Why we study this state: To see how output gaps cause factor prices to change and why real GDP tends to return to Y* The Long Run • Key assumptions:  Factor prices are fully adjusted/endogenous  Technology and factor supplies (and thus Y*) are changing • What happens: Potential GDP (Y*) grows over the long run • Why we study this state: To understand the nature of long run economic growth 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- land, labour, and capital- are fully employed • When a nation’s actual output diverges from its potential output, the difference is called the output gap Factor Prices and the Output Gap • Two assumptions regarding factor prices and the output gap: 1. When real GDP is above potential output, there will be pressure on factor prices to rise because of a higher than normal demand for factor inputs 2. When real GDP is below potential output, there will be pressure on factor prices to fall because of a lower than normal demand for factor inputs • In the absence of an output gap, the presence of ongoing inflation influences factor prices, especially wages • Output Above Potential, Y > Y*  Inflationary gap occurs when actual output is greater than potential GDP leading to excess demand for all factor prices  labour shortages  bid workers away from other firms in order to maintain high levels of outputs  bargaining power = upward pressure on wages  increase unit costs  higher prices  AS shifts up  The boom that is associated with an inflationary gap generates a set of conditions- high profit for firms and an excess demand for labour-that tends to cause wages (and other factor prices) to rise • Output Below Potential, Y < Y*  Recessionary gap occurs when actual output is less than potential GDP leading to excess supply of all factor inputs Below normal sales Seek reductions in wages  Reduce unit costs  will require a lower price  AS shifts down  The slump that is associated with a recessionary gap generates a set of conditions- low profits for firms and an excess supply of labour- that tends to cause wages (and other factor prices) to fall • Downward Wage Stickiness  Both upward and downward adjustments to waves and unit costs do occur, but there are differences in the speed at which they typically operate; booms can cause wages to rise rapidly; recessions usually cause wages to fall only slowly  This downward wage stickiness implies that the downward shift in the AS curve and the downward pressure on the price level are quite weak • The Phillips Curve  Phillips Curve- Originally, a relationship between the unemployment rate and the rate of change of nominal wages; now often drawn as a relationship between GDP and the rate of change of nominal wages  Wages tended to fall in periods of high unemployment and rise in periods of low unemployment; negative relationship between unemployment and rate of change in wages • Inflationary and Recessionary Gaps  Inflationary Gap: high rates of unemployment occur when Y < Y*  Recessionary Gap: temporary inflation 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 is assumed to cause wages and other factor prices to adjust, eventually bringing the equilibrium level of output back to potential; in this model therefore, the level of potential output acts like an “anchor” for the economy 24.2 Aggregate Demand and Supply  Shocks Expansionary AD Shocks • The adjustment in wages and other factor prices eventually eliminates any boom caused by a demand shock; real GDP returns to its potential level • View FIGURE 24-2 for “The Adjustment Process Following a Positive AD Shock”  A positive AD shock first raises prices and output along the AS curve; it then induces a shift of the AS curve that further raises prices but lowers output along the new AD curve Contractionary AD Shocks • Flexible Wages  Flexible wages that fall rapidly in the presence of a recessionary gap provide an automatic adjustment process that pushes the economy back quickly toward potential output  View FIGURE 24-3 for “The Adjustment Process Following a Negative AD Shock” o A negative AD shock first lowers the price level and GDP along the AS curve and then induces a (possibly slow) shift of the AS curve that further lowers prices but raises output along the new AD curve • Sticky Wages  If wages are downwardly sticky, the economy’s adjustment process is sluggish and thus will not quickly eliminate a recessionary gap Aggregate Supply Shocks • View FIGURE 24-4 for “The Adjustment Process Following a Negative AS Shock”  A negative AS shock caused by an increase in input prices causes real GDP to fall and the price level to rise; the economy’s adjustment process then reverses the AS shift and returns the economy to its starting point • Exogenous changes in input prices cause the AS curve to shift, creating an output gap; the adjustment process then reverses the initial AS shift and brings the economy back to potential output and the initial price level Long Run Equilibrium • Economy is in long run equilibrium when the intersection of the AD and AS curves occurs at Y* • Vertical line at Y* is the long run aggregate supply curve; the relationship between the price level and the amount of output supplied by firms after all factor prices
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