Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved Economics NINTH EDITION Chapter 15 Modern Macroeconomics: From the Short Run to the Long Run Insert Cover Picture

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved Learning Objectives 15.1 Describe the key difference between the short run and long run in macroeconomics Demonstrate graphically how the economy can return to full employment Analyze monetary neutrality and crowding out using graphs Assess how classical economic doctrines relate to modern macroeconomics

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.1 LINKING THE SHORT RUN AND THE LONG RUN (1 of 2) The Difference between the Short and Long Run ● Short run in macroeconomics The period of time in which prices do not change or do not change very much. ● 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 we expect to happen in the short run, as Keynes thought, or what we expect 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?

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.1 LINKING THE SHORT RUN AND THE LONG RUN (2 of 2) Wages and Prices and Their Adjustment over Time REAL - NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not its “face” value. ● Wage–price spiral The process by which changes in wages and prices cause further changes in wages and prices. TABLE 15.1 Unemployment, Output, and Wage and Price Changes When unemployment is below the natural rate … When unemployment is above the natural rate … output is above potential. wages and prices rise. output is below potential wages and prices fall.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved APPLICATION 1 SECULAR STAGNATION? APPLYING THE CONCEPTS #1: Why have some economists revived the idea of “secular stagnation”? In the 1930s Alvin Hansen, argued the economy suffered fro secular stagnation. According to this theory, there was not enough aggregate demand to bring the economy t full employment and the natural adjustment process would not work as interest rate could not fall enough. The only remedy was government spending. World War II brought enough demand and the concept disappeared. Lawrence Summers, former U.S. Secretary of the Treasury resurrected the theory. He believes that a series of structural factors have decreased the demand for investment goods and interest rates cannot fall far enough to create sufficient aggregate demand. He believes infrastructure spending makes sense at this time and will increase aggregate demand He believes that easy credit fuelled a stock market boom n the late 1990s and later the housing boom in the 2000s and that is the only reason we have had sufficient demand in the last few decades. Critics say the economy has grown consistently since the last recession and the unemployment rate in 2015 was at or near full employment. Although infrastructure spending is a good idea, it is not necessary to achieve full employment.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (1 of 6) 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. Aggregate demand curve A curve that shows the relationship between the level of prices and the quantity of real GDP demanded. 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 and technology.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (2 of 6) Returning to Full Employment from a Recession If the economy is operating below full employment, as shown in Panel A, prices will fall, shifting down the short- run aggregate supply curve, as shown in Panel B. This will return output to its full- employment level.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (3 of 6) Returning to Full Employment from a Boom If the economy is operating above full employment, as shown in Panel A, prices will rise, shifting the short-run aggregate supply curve upward, as shown in Panel B. This will return output to its full-employment level.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (4 of 6) 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.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (5 of 6) Economic Policy and the Speed of Adjustment Rather than letting the economy naturally return to full employment at point b, economic policies could be implemented to increase aggregate demand from AD0 to AD1 to bring the economy to full employment at point c. The price level within the economy, however, would be higher.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (6 of 6) Liquidity Traps or Zero Lower Bound ● Liquidity trap A situation in which nominal interest rates are so low, they can no longer fall. Political Business Cycles ● Political business cycle The effects on the economy of using monetary or fiscal policy to stimulate the economy before an election to improve re election prospects.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved APPLICATION 2 ELECTIONS, POLITICAL PARTIES, AND VOTER EXPECTATIONS APPLYING THE CONCEPTS #2: What are the links between presidential elections and macroeconomic performance? The original political business cycle theories focused on incumbent presidents trying to manipulate the economy in their favour to gain re election. Subsequent research began to incorporate other, more realistic factors. The first innovation was to recognize that political parties could have different goals or preferences. Republicans historically have been more concerned about fighting inflation, whereas Democrats have placed more weight on reducing unemployment. The second major innovation was to recognize that the public would anticipate that politicians will try to manipulate the economy. If the public is not sure who will win the election, the outcome will be a surprise to them—a contractionary surprise if Republicans win and an expansionary surprise if Democrats win. This suggests that economic growth should be less if Republicans win and greater if Democrats win. The postwar U.S. evidence is generally supportive of this theory

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (1 of 7) REAL - NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not its “face” value.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (2 of 7) With the economy initially below full employment, the price level falls, as shown in Panel A, stimulating output. In Panel B, the lower price level decreases the demand for money and leads to lower interest rates at point d. In Panel C, lower interest rates lead to higher investment spending at point f. As the economy moves down the aggregate demand curve from point a toward full employment at point b in Panel A, investment spending increases along the aggregate demand curve.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (3 of 7) 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.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (4 of 7) The Long-Run Neutrality of Money As the Fed increases the supply of money, the aggregate demand curve shifts from AD0 to AD1 and the economy moves to point a. In the long run, the economy moves to point b.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.3 THE ECONOMICS BEHINE THE ADJUSTMENT PROCESS (5 of 7) The Long-Run Neutrality of Money Starting at full employment, an increase in the supply of money from M s 0 to M s 1 will initially reduce interest rates from r F to r 0 (from point a to point b) and raise investment spending from I F to I 0 (point c to point d). We show these changes with the red arrows. The blue arrows show that as the price level increases, the demand for money increases, restoring interest rates and investment to their prior levels—r F and I F, respectively. Both money supplied and money demanded will remain at a higher level, though, at point e.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (6 of 7) The Long-Run Neutrality of Money ● Long-run neutrality of money A change in the supply of money has no effect on real interest rates, investment, or output in the long run.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (7 of 7) Crowding Out in the Long Run Starting at full employment, an increase in government spending raises output above full employment. As wages and prices increase, the demand for money increases, as shown in Panel A, raising interest rates from r 0 to r 1 (point a to point b) and reducing investment from I 0 to I 1 (point c to point d ). The economy returns to full employment, but at a higher level of interest rates and a lower level of investment spending.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved APPLICATION 3 INCREASING HEALTH-CARE EXPENDITURES AND CROWDING OUT APPLYING THE CONCEPTS #3: Will increases in health-care expenditures crowd out consumption or investment spending? In 1950, health-care expenditures in the United States were 5.2 percent of GDP; by 2000, this share had risen to 15.4 percent. Since 1950, the average life span has increased by 1.7 years per decade. Two economists, Charles I. Jones and Robert E. Hall, go further and suggest normal increases in economic growth will propel health-care expenditures to approximately 30 percent of GDP by mid- century. Their argument is that as societies grow wealthier, individuals face the tradeoff of buying more goods (automobiles or cars) to enjoy their current life span or spending more on health care to extend their lives. Assuming this argument is correct and health-care expenditures increase, what other component of GDP will fall? If investment is crowded out, living standards would fall in the long run, reducing the ability to consume both health and non-health goods. Spending on health would then come at the expense of spending on consumer durables or larger houses. That would be the preferred outcome.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved 15.4 CLASSICAL ECONOMICS IN HISTORICAL PERSPECTIVE Say’s Law 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 for extended periods of time. Keynesian and Classical Debates 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.

Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved KEY TERMS Aggregate demand curve Liquidity trap Long-run aggregate supply curve Long run in macroeconomics Long-run neutrality of money Political business cycle Short-run aggregate supply curve Short run in macroeconomics Wage–price spiral