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Chapter

Week 7 chapter notes


Department
Economics for Management Studies
Course Code
MGEA06H3
Professor
Iris Au

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of 3
Chapter 24 From the Short Run to the Long Run: The Adjustment of
Factor Prices Notes
x defining characteristics of short run in macroeconomic model are:
o factor prices are assumed to be exogenous; they may change, but any change is not explained within the model
o technology and factor supplies are assumed to be constant (and therefore Y* is constant)
x theory of adjustment process that takes the economy from short run to long run is based on following assumptions:
o factor prices are assumed to be flexible and to adjust to output gaps
o technology and factor supplies are assumed to be constant (and therefore Y* is constant)
x defining characteristics of long run in macro model are:
o factor prices are assumed to have fully adjusted to any output gap
o technology and factor supplies are assumed to be changing
24.1 The Adjustment Process
Potential Output and the Output Gap
x potential output is total output that can be produced when all productive resources are being used at normal rates of utilization
x when a nation’s actual output diverges from its potential output, difference is called output growth
Factors Prices and the Output Gap
x when real GDP is above potential output, demand for factors will be high and there will be pressure on factor prices to rise
x when real GDP is below potential output, demand for factors will be low and there will be pressure on factor prices to fall
x boom that is associated with an inflationary gap generates a set of conditions—high profits for firms and unusually large demand
for labour—that tends to cause wages (and other factor prices) to rise
x the slump that is associated with a recessionary gap generates a set of conditions—low profits for firms and low demand for
labour—that tends to cause wages (and other factor prices) to fall
x both upward and downward adjustments to wages 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
x Phillips curve—originally, a relationship between the unemployment rate and the rate of change of money wages; now often
drawn as a relationship between GDP and the rate of change of money wages
Potential Output as an “Anchor”
x following an aggregate demand or supply shock, the short-run equilibrium level of output may be different than 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 Demand and Supply Shocks
Expansionary AD Shocks
x adjustment in wages and other factor prices eliminates any boom caused by demand shock; real GDP returns to its potential level
Contractionary AD Shocks
x flexible wages that fall rapidly in the presence of a recessionary gap provide an automatic adjustment process that pushes the
economy back toward potential output; if wages are downwardly sticky, the economy’s adjustment process is sluggish and thus
recessionary gaps may not be eliminated quickly, if at all
Aggregate Supply Shocks
x 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
x in the long run, real GDP is determined solely by Y*; the role of aggregate demand is only to determine the price level
24.3 Fiscal Stabilization Policy
The Basic Theory of Fiscal Stabilization
x when the economy’s adjustment process is slow to operate, or produces undesirable side affects such as rising prices, there is a
potential stabilization policy for fiscal policy
x the paradox of thrift—the idea that an increase in savings reduces the level of real GDP—is only true in the short run; in the long
run, the path of real GDP is determined by the path of potential output; the increase in saving has the long-run effect of
increasing investment and therefore increasing potential output
x automatic stabilizers—elements of the tax-and-transfer system that reduce the responsiveness of real GDP to changes in AE
x even in the absence of discretionary fiscal stabilization policy, the presence of net taxes that vary with national income provides
the economy with an automatic stabilizer
Practical Limitations of Discretionary Fiscal Policy
x decision lag—the period of time between perceiving some problem and reaching a decision on what to do about it
x execution lag—the time that it takes to put policies in place after a decision has been made
x fine tuning—the attempt to maintain output at its potential level by means of frequent changes in fiscal or monetary policy
x gross tuning—the use of macroeconomic policy to stabilize the economy such that large deviations from potential output do not
persist for extended periods of time
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Fiscal Policy and Growth
x even though an increase in government purchases may have no effect on the current level of potential output, the crowding out of
private investment implies that the growth rate of potential output may be lower than it would otherwise be
x reductions in tax rates generate a short-run demand stimulus and may also generate a longer-run increase in the level and growth
rate of potential output
Summary
24.1 The Adjustment Process
x Potential output, Y*, is the level of real GDP at which all factors of product are being used at their normal rates of utilization.
x The output gap is the difference between potential output and the actual level of real GDP, the latter determined by the
intersection of the AS and AD curves.
x An inflationary gap means that Y is greater than Y*, and hence there is excess demand in factor markets. As a result, wages and
other factor prices rise, causing firms’ unit costs to rise. The AS curve shifts upward, and the price level rises.
x A recessionary gap means that Y is less than Y*, and hence there is excess supply in factor markets. Wages and other factor
prices falls, but perhaps very slowly. As firms’ unit costs fall, the AS curve gradually shifts downward, eventually returning
output to potential.
x In our macro model, the level of potential output, Y*, acts as an “anchor” for the economy. Given the short-run equilibrium as
determined by the AD and AS curves, wages and other factor prices will adjust, shifting the AS curve, until output returns to Y*.
24.2 Demand and Supply Shocks
x Beginning from a position of potential output, an expansionary demand shock creates an inflationary gap, causing wages and
other factor prices to rise. Firms’ unit costs rise, shifting the AS curve upward and bringing output back towards Y*.
x Beginning from a position of potential output, a contractionary demand shock creates a recessionary gap. Because factor prices
tend to be sticky downwards, the adjustment process tends to be slow, and a recessionary gap tends to persist for some time.
x Aggregate supply shocks, such as those caused by changes in the prices of inputs, lead the AS curve to shift, changing real GDP
and the price level. But the economy’s adjustment process reserves the shift in AS, tending eventually to bring the economy back
to its initial level of output and prices.
x In the short run, macroeconomic equilibrium is determined by the intersection of the AD and AS curves. In the long run, the
economy is in equilibrium only when real GDP is equal to potential output. In the long run, the price level is determined by the
intersection of the AD curve and the vertical Y* curve.
x Shocks to the AD or AS curves can change real GDP in the short run. Only changes in the level of potential output can change
output in the long run.
24.3 Fiscal Stabilization Policy
x In principle, fiscal policy can be used to stabilize output at Y*. To remove a recessionary gap, governments can shift AD to the
right by cutting taxes or increasing spending. To remove an inflationary gap, governments can pursue the opposite policies.
x In the short run, increases in desired saving on the part of firms, households, and governments lead to reductions in real GDP.
This phenomenon is called the paradox of thrift. In the long run, the paradox of thrift does not apply, and increased saving will
lead to increased investment and economic growth.
x Because government tax and transfer programs tend to reduce the size of the multiplier, they act as automatic stabilizers. When
real GDP changes, disposable income changes by less because of taxes and transfers.
x Discretionary fiscal policy is subject to decision lags and execution lags that limit its ability to take effect quickly. Some
economists argue that these limitations are so severe that discretionary fiscal policy should never be used for stabilization
because it will end up increasing instability. Others argue that the economy’s adjustment process works so slowly that
discretionary fiscal policy can play a useful role in stabilizing the economy.
x Fiscal policy has different effects in the short and long run. In the short run, a fiscal expansion created by an increase in
government purchases (G) will increase real GDP. In the long run, the rise in G will “crowd out” private spending. If private
investment is crowded out, the growth rate of potential output may be reduced.
x In the short run, a fiscal expansion created by a reduction in the income taxes has a similar effect on real GDP. In the long run, if
the tax reduction leads to more investment and work effort, there will be a positive effect on the level and growth rate of
potential output.
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Chapter 25 The Difference Between Short-Run and Long-Run
Macroeconomics Notes
25.2 Accounting for Changes in GDP
x when studying long-run trends in GDP, economists focus on change in potential output; when studying short-run fluctuations,
economists focus on the change in the output gap
GDP Accounting: The Basic Principle
x GDP = F ×(FE / F) × (GDP / FE)
x the three components that make up this equation are:
1. F is the economys factor supply; it is the total amount of all factors of production that the economy currently possesses.
2. FE / F is the factor utilization rate; it is fraction of the total supply of factors that is actually used or employed at any time.
3. GDP / FE is a simple measure of productivity because it shows the amount of output (GDP) per unit of input employed (FE).
x any change in GDP can be decomposed into a change in factor supply, a change in factor utilization, and a change in productivity
x changes in the economys supply of labour and capital occur gradually, but over periods of many years their growth is
considerable; as a result, changes in factor supply are important for explaining long-run changes in output, but relatively
unimportant for explaining short-run changes
x the economy’s level of productivity changes only gradually from year to year, but grows substantially over periods of many
years; as a result, productivity growth is very important for explaining long-run changes in output, but less important for
explaining short-run changes
x the factor utilization rate fluctuates in response to short-run changes in output caused by aggregate demand or aggregate supply
shocks; over time, however, excess supply or excess demand for factors causes an adjustment in factor prices that brings the
factor utilization rate back to its “normal” level
x changes in the factor utilization rate are important for explaining short-run changes in GDP; but after factor prices have fully
adjusted, GDP returns to Y* and the factor utilization rate returns to itsnormal” level; as a result, changes in the factor
utilization rate are not important for explaining long-run changes in GDP
25.3 Policy Implications
x when studying short-run fluctuations, economists focus on the deviations of actual output from potential output; when studying
long-run changes, economists focus on changes in potential output
x fiscal and monetary policies affect the short-run level of GDP because they alter the level of demand, and thus the position of the
AD curve; but unless they are able to affect the level of potential output, Y*, they will have no long-run effect on GDP
Summary
25.1 Two Examples
x Macroeconomic variables behave differently over the short run than over the long run. One example: a monetary policy designed
to reduce inflation and nominal interest rates in the long run requires an increase in interest rates in the short run. Another
example: an increase in households’ or firms’ saving rates will reduce the level of output in the short run, but it will increase
output in the long run.
x In the short run, there is some adjustment of output and employment, but little adjustment of wages and prices. In the long run,
full adjustment of wages and prices is assumed to take place.
25.2 Accounting for Changes in GDP
x All changes in GDP can be accounted for by changes in one or more of the following three variables: (1) supply of factors, (2)
factor utilization rates, and (3) factor productivity.
x Long-run changes in GDP are caused mostly by changes in factor supplies and factor productivity; the utilization rate of factors
does not change significantly over the long run.
x Short-run changes in GDP are caused mostly by changes in the factor utilization rate; factor supplies and productivity have
relatively minor short-run fluctuations.
25.3 Policy Implications
x When studying short-run fluctuations, economists focus on changes in output gap and tend to ignore changes in potential output.
When studying long-run fluctuations, economists focus on changes in potential output and ignore changes in the output gap.
x Fiscal and monetary policies affect GDP in the short run because they affect the level of demand, and thus the position of the AD
curve. Unless they are able to affect the level of potential output, they will have no long-run effect on GDP.
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