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 Objectives After studying this chapter, you will be able to 24.1 The Adjustment Process explain why output gaps cause wages and other factor prices to change. describe how induced changes in factor prices affect firms' costs and shift the AS curve. 24.2 Aggregate Demand and Supply Shocks explain why real GDP gradually returns to potential output following an AD or AS shock. 24.3 Fiscal Stabilization Policy understand why lags and uncertainty place limitations on the use of fiscal stabilization policy. Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

The Adjustment of Factor Prices 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 Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

Full-Employment Equilibrium Potential GDP Price level AS When equilibrium occurs at full-employment output AD Figure 5.8A YFE Real GDP

Table 24-1 Three Microeconomic States Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

24.1 The Adjustment Process Potential Output and the Output Gap Fig. 24-1 Output Gaps in the Short Run (i) A recessionary gap, Y < Y* (ii) An inflationary gap, Y > Y* Output Gap = Y - Y* Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

Self-Test a. What is the equilibrium level of prices and real GDP? b. What if the price level were 95? And if it was 115? Price Index AD AS 90 $1200 $950 95 1150 1025 100 1100 105 1050 110 1000 1190 115 950 1220

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 Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

recessionary output gap 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 Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

Adjustment asymmetry: inflationary output gaps typically raise wages rapidly recessionary output gaps often reduce wages only slowly (downward wage stickiness) This general adjustment process—from output gaps to factor prices—is summarized by the Phillips curve. Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

The Phillips Curve and the Adjustment Process The Phillips curve was originally drawn as a negative relationship between the unemployment rate and the rate of change in nominal wages. Y > Y* => excess demand for labour => wages rise Y < Y* => excess supply for labour => wages fall Y = Y* => no excess supply/demand => wages constant EXTENSIONS IN THEORY 24-1 The Phillips Curve and the Adjustment Process Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

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 Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

24.2 Aggregate Demand and Supply Shocks Fig. 24-2 The Adjustment Process Following a Positive AD Shock Expansionary AD Shocks The economy's adjustment process eventually eliminates any boom caused by a demand shock, returning Y to Y*. (ii) Wage adjustment shifts AS Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

Contractionary AD Shocks Fig. 24-3 The Adjustment Process Following a Negative AD Shock The economy's adjustment process works following negative demand shocks too. although it may be slower because of "sticky wages" (ii) Wage adjustment shifts AS Copyright © 2014 Pearson Canada Inc. Chapter 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. Copyright © 2014 Pearson Canada Inc. 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 Copyright © 2014 Pearson Canada Inc. 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. Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

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 (i) A rise in aggregate demand (ii) A rise in potential output Copyright © 2014 Pearson Canada Inc. 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. Chapter 24, Slide

a. What is the equilibrium level of prices and real GDP? b. What if AS increases by $200 at each price level? AD Price Index AS1 AS2 $1950 90 $1670 1900 95 1700 1850 100 1740 1800 105 1750 110 1890 115 2000

What are the equilibrium values of price & real GDP? What type of equilibrium is this, if Potential GDP is $1500? c. Assume productivity increases AS by $300 at each price level? Price Index AD AS1 AS2 90 $1700 $1200 95 1650 1240 100 1600 1300 105 1550 1380 110 1500 115 1450 1630

MyEconLab www.myeconlab.com 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. Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

The Basic Theory of Fiscal Stabilization Fig. 24-6 The Closing of a Recessionary Gap A recessionary gap may be closed by a (possibly slow) rightward shift in the AS curve or by a rightward shift in AD. Copyright © 2014 Pearson Canada Inc. 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. Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

Fiscal Policy in the Great Depression 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 Copyright © 2014 Pearson Canada Inc. 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 Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

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

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

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 Copyright © 2014 Pearson Canada Inc. Chapter 24, Slide

Review Real GDP Rate of Wage Change Economy A 300 -1% Economy B 320 How is the adjustment asymmetry demonstrated when comparing Economy A to Economy E? A) The output gap is larger in Economy A, yet wages are changing more slowly. B) The output gap is much larger in Economy E, so wages are changing at a faster rate. C) The size of the output gap is the same in Economies A and E but wages are falling more slowly in A than they are rising in E. D) The size of the output gap is the same in Economies A and E, but wages are rising in A and falling in E. E) There is insufficient data with which to observe the adjustment asymmetry.   Real GDP Rate of Wage Change Economy A 300 -1% Economy B 320 -0.5% Economy C 340 0% Economy D 360 +3.5 Economy E 380 +6% © 2014 Pearson Education Canada Inc.

Review Following the positive AS shock shown in the diagram, the adjustment process will take the economy to a long-run equilibrium where the price level is ________ and real GDP is ________. A) 60; 1000 B) 110; 1000 C) 90; 1200 D) 60; 1300 E) 90; 750 © 2014 Pearson Education Canada Inc.

Review As a global recession began in late 2008, the governments of all major economies searched for policy responses to dampen the effects of the recession. In general, governments were aiming to A) shift the AS curve to the right through large increases in government spending. B) shift the AD curve to the left by decreasing tax rates. C) shift the AS curve to the left by increasing wage rates. D) increase potential GDP. E) shift the AD curve to the right through large increases in government spending. © 2014 Pearson Education Canada Inc.