chapter 24: from the short run to the long run: the adjustment of factor prices copyright © 2014...

Chapter 24: From the Short Run

to the Long Run:The Adjustment of

Factor Prices

Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives

Section Learning ObjectivesAfter studying this chapter, you will be able to

24.1 The Adjustment Process

1. explain why output gaps cause wages and other factor prices to change.

2. describe how induced changes in factor prices affect firms' costs and shift the AS curve.

24.2 Aggregate Demand and Supply Shocks

3. explain why real GDP gradually returns to potential output following an AD or AS shock.

24.3 Fiscal Stabilization Policy

4. understand why lags and uncertainty place limitations on the use of fiscal stabilization policy.

Copyright © 2014 Pearson Canada Inc. 2Chapter 24, Slide

The Short Run

• factor prices are assumed to be constant

• technology and factor supplies are assumed to be constant

The Adjustment of Factor Prices

• factor prices are flexible

• technology and factor supplies are constant

The Long Run

• factor prices have fully adjusted

• technology and factor supplies are changing

3Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

24.1 The Adjustment Process

Potential Output and the Output Gap

4Copyright © 2014 Pearson Canada Inc.

Output Gap = Y - Y*

Fig. 24-1 Output Gaps in the Short Run

(i) A recessionary gap, Y < Y* (ii) An inflationary gap, Y > Y*

Chapter 24, Slide

Factor Prices and the Output Gap

When Y > Y*, the demand for labour (and other factor services) is relatively high

• an inflationary output gap

During an inflationary output gap there are high profits for firms and unusually large demand for labour

• wages and unit costs tend to rise


When Y < Y*, the demand for labour (and other factor services) is relatively low

• recessionary output gap

During a recessionary gap there are low profits for firms and low demand for labour

• wages and unit costs tend to fall*

* assuming no inflation and productivity growth


Adjustment asymmetry:

• inflationary output gaps typically raise wages rapidly

• recessionary output gaps often reduce wages only slowly (downward wage stickiness)


Potential Output as an "Anchor"

Suppose an AD or AS shock pushes Y away from Y* in the short run.

As a result, wages and other factor prices will adjust, until Y returns to Y*.

Y* is an "anchor" for output

When Y = Y*, the unemployment rate equals NAIRU, U*.

• there is both structural and frictional unemployment


Expansionary AD Shocks

The economy's adjustment process eventually eliminates any boom caused by a demand shock, returning Y to Y*.


24.2 Aggregate Demand and Supply Shocks

Fig. 24-2 The Adjustment Process Following a Positive AD Shock

(ii) Wage adjustment shifts ASChapter 24, Slide

Contractionary AD Shocks

The economy's adjustment process works following negative demand shocks too.

• although it may be slower because of "sticky wages"


Fig. 24-3 The Adjustment Process Following a Negative AD Shock

(ii) Wage adjustment shifts ASChapter 24, Slide

Aggregate Supply Shocks

After a negative supply shock, the adjustment of factor prices reverses the AS shift and returns real GDP to Y*.


Example: Consider an increase in the world price of some important raw materials.

Chapter 24, Slide

It Matters How Quickly Wages Adjust!

Following either a demand or supply shock, the speed that output returns to Y* depends on wage flexibility.

Flexible wages provide an adjustment process that quickly pushes the economy back toward potential output.

But if wages are slow to adjust, the economy's adjustment process is sluggish and thus output gaps tend to persist.


EXTENSIONS IN THEORY 24-2

The Business Cycle: Additional Pressures for Adjustment

Chapter 24, Slide

Long-Run Equilibrium

The economy is in a state of long-run equilibrium when factor prices are no longer adjusting to output gaps:

Y = Y*

The vertical line at Y* is sometimes called:

• the long-run aggregate supply curve, or

• the classical aggregate supply curve

There is no relationship in the long run between the price level and potential output.


Fig. 24-5 Changes in Long-Run Equilibrium

In the long run, Y is determined only by potential output— aggregate demand determines P.

For a given AD curve, long-run growth in Y* results in a lower price level

14Copyright © 2014 Pearson Canada Inc. (ii) A rise in potential output

(i) A rise in aggregate demand

Chapter 24, Slide

24.3 Fiscal Stabilization Policy

The motivation for fiscal stabilization policy is to reduce the volatility of aggregate outcomes.

When an AD or AS shock pushes Y away from Y* the alternatives are:

• use fiscal stabilization policy

• wait for the recovery of private sector demand a shift in the AD curve

• wait for the economy's adjustment process a shift in the AS curve

Copyright © 2014 Pearson Canada Inc. 15Chapter 24, Slide


MyEconLab

www.myeconlab.co

m

Though macroeconomists tend to focus on fluctuations in real GDP when describing business cycles, there is no single "best" measure of the changes in economic activity. For a detailed description of several popular measures of changes in the level of economic activity—including GDP growth, housing starts, and capacity utilization—look for Several Measures of Economic Fluctuations in Canada in the Additional Topics section of this book's MyEconLab.

Chapter 24, Slide

The Basic Theory of Fiscal Stabilization

A recessionary gap may be closed by a (possibly slow) rightward shift in the AS curve or by a rightward shift in AD.


Fig. 24-6 The Closing of a Recessionary Gap

Chapter 24, Slide

Fig. 24-7 The Closing of an Inflationary Gap

An inflationary gap may be removed by a leftward shift of AS or by a leftward shift in AD.


The Paradox of Thrift

In the short run, an increase in desired saving leads to a reduction in GDP—and possibly no change in aggregate saving!

In the long run, an increase in desired saving has the following effects:

• the price level falls

• investment rises

• aggregate output returns to Y*

The paradox of thrift does not apply in the long run.


LESSONS FROM HISTORY 24-1

Fiscal Policy in the Great Depression

Chapter 24, Slide

Automatic vs. Discretionary Fiscal Policy

Discretionary fiscal stabilization policy occurs when the government actively changes G and/or T in an effort to steer real GDP.

Automatic fiscal stabilization occurs because of the design of the tax and transfer system:

• as Y changes, transfers and taxes both change

• the size of the simple multiplier is reduced

• the output response to shocks is dampened


The marginal propensity to spend on national income is:

z = MPC(1 – t) – m

The simple multiplier is:

Simple multiplier = 1/ (1 – z)

The lower is the net tax rate (t), the larger is the simple multiplier and thus the less stable is real GDP in response to shocks to autonomous spending.


Practical Limitations as Discretionary Fiscal Policy

Most economists agree that automatic fiscal stabilizers are desirable and generally work well, but they have concerns about discretionary fiscal policy.

Limitations come from:

• long and uncertain lags

• temporary versus permanent changes in policy

• the impossibility of "fine tuning"


Fiscal Policy and Growth

Fiscal stabilization policy will generally have consequences for economic growth.

An increase in G:

• Increases Y in the short run

• In the long run, the rate of growth of Y* may be:

– lower if private investment is lower in the new long-run equilibrium.

– higher if G increases the productivity of private-sector production.

A reduction in t:

• There is no tradeoff between short and long run


chapter 24: from the short run to the long run: the adjustment of factor prices copyright © 2014...

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