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MGEA06H3 (35)
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Week 7 chapter notes

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Department
Economics for Management Studies
Course Code
MGEA06H3
Professor
Iris Au

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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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Description
Chapter 24 From the Short Run to the Long Run: The Adjustment of Factor Prices Notes N 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) N 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) N 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 N potential output is total output that can be produced when all productive resources are being used at normal rates of utilization N when a nations actual output diverges from its potential output, difference is called output growth Factors Prices and the Output Gap N when real GDP is above potential output, demand for factors will be high and there will be pressure on factor prices to rise N when real GDP is below potential output, demand for factors will be low and there will be pressure on factor prices to fall N boom that is associated with an inflationary gap generates a set of conditionshigh profits for firms and unusually large demand for labourthat tends to cause wages (and other factor prices) to rise N the slump that is associated with a recessionary gap generates a set of conditionslow profits for firms and low demand for labourthat tends to cause wages (and other factor prices) to fall N 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 N Phillips curveoriginally, 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 N 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 bri
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