15 Modern Macroeconomics: From the Short-Run to the Long- Run

short run in macroeconomics The period of time in which prices do not change or do not change very much. LINKING THE SHORT RUN AND THE LONG RUN The Difference Between the Short and Long Run long run in macroeconomics The period of time in which prices have fully adjusted to any economic changes. Should economic policy be guided by what is expected to happen in the short run, as Keynes thought, or what is expected to happen in the long run, as Friedman thought? To answer this question, we need to know two things: 1 How does what happens in the short run determine what happens in the long run? 2 How long is the short run?

LINKING THE SHORT RUN AND THE LONG RUN Wages and Prices and Their Adjustment over Time wage–price spiral The process by which changes in wages and prices cause further changes in wages and prices.

aggregate demand curve A curve that shows the relationship between the level of prices and the quantity of real GDP demanded. HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT Using aggregate demand and aggregate supply, we can illustrate graphically how changing prices and wages help move the economy from the short to the long run. 1 Aggregate demand. 2 Aggregate supply. short-run aggregate supply curve A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand. long-run aggregate supply curve A vertical aggregate supply curve that reflects the idea that in the long run, output is determined solely by the factors of production.

HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT  How the Economy Recovers from a Downturn WITHOUT Intervention Returning to Full Employment from a Recession

HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT  How the Economy Returns from a Boom WITHOUT Intervention Returning to Full Employment from a Boom

HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT Returning to Full Employment from a Boom In summary: If output is less than full employment, prices will fall as the economy returns to full employment. If output exceeds full employment, prices will rise and output will fall back to full employment.

MOVING THE ECONOMY BACK TO FULL EMPLOYMENT Economic Policy and the Speed of Adjustment Liquidity Traps liquidity trap A situation in which nominal interest rates are so low, they can no longer fall.

political business cycle The effects on the economy of using monetary or fiscal policy to stimulate the economy before an election to improve reelection prospects. UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS

 How the Changing Price Level Restores the Economy to Full Employment

ECONOMICS OF THE ADJUSTMENT PROCESS Why changes in wages and prices restore the economy to full employment: (1) Changes in wages and prices change the demand for money. (2) This changes interest rates, which then affect aggregate demand for goods and services and ultimately GDP.

The Long-Run Neutrality of Money ECONOMICS OF THE ADJUSTMENT PROCESS

The Long-Run Neutrality of Money long-run neutrality of money An increase in the supply of money has no effect on real interest rates, investment, or output in the long run. ECONOMICS OF THE ADJUSTMENT PROCESS

Crowding Out in the Long Run  Crowding Out in the Long Run crowding out The reduction in investment, or other component of GDP, in the long run caused by an increase in government spending. ECONOMICS OF THE ADJUSTMENT PROCESS

CLASSICAL ECONOMICS IN HISTORICAL PERSPECTIVE Say’s Law Keynesian and Classical Debates Classical economics is often associated with Say’s law, the doctrine that “supply creates its own demand.” Keynes argued that there could be situations in which total demand fell short of total production in the economy—at least for extended periods of time. If wages and prices are not fully flexible, then Keynes’s view that demand could fall short of production is more likely to hold true. However, over longer periods of time, wages and prices do adjust and the insights of the classical model are restored.