Chapter 24: From the Short Run to the Long Run: The Adjustment of Factor Prices Copyright © 2017 Pearson Canada Inc.

Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 24.1 Three Economic States 1. describe the three different macroeconomic states and the underlying assumptions for each one. 24.2 The Adjustment Process 2. explain why output gaps cause wages and other factor prices to change. 3. describe how changes in factor prices affect firms ' costs and shift the AS curve. 24.3 Aggregate Demand and Supply Shocks 4. explain why real GDP gradually returns to potential output following an AD or AS shock. 24.4 Fiscal Stabilization Policy 5. understand why lags and uncertainty place limitations on the use of fiscal stabilization policy. Copyright © 2017 Pearson Canada Inc.

24.1 Three Macroeconomic States The Short Run The assumptions of the model in the short run are: Factor prices are assumed to be exogenous; they may change, but any change is not explained within the model. Technology and factor supplies are assumed to be constant (and therefore Y* is constant). Copyright © 2017 Pearson Canada Inc.

The Adjustment of Factor Prices The assumptions of the theory of the adjustment process are: Factor prices are assumed to adjust in response to output gaps. Technology and factor supplies are assumed to be constant (and therefore Y* is constant). Copyright © 2017 Pearson Canada Inc.

The Long Run The assumptions of the model in the long run are: Factor prices are assumed to have fully adjusted to any output gap. Technology and factor supplies are assumed to be changing. Copyright © 2017 Pearson Canada Inc.

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

24.2 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 © 2017 Pearson Canada Inc.

Factor Prices and the Output Gap Output Above Potential, Y > Y* Because firms are producing beyond their normal capacity output, there is an excess demand for all factor inputs, including labour. Workers will find that they have considerable bargaining power, and they will put upward pressure on wages. The boom that is associated with an inflationary gap generates a set of conditions—high profits for firms and an excess demand for labour—that tends to cause wages (and other factor prices) to rise. Copyright © 2017 Pearson Canada Inc.

Output Below Potential, Y < Y* Because firms are producing below their normal capacity output, there is an excess supply of all factor inputs, including labour. Firms will have below-normal sales and not only will resist upward pressures on wages but also may seek reductions in wages. The slump that is associated with a recessionary gap generates a set of conditions—low profits for firms and an excess supply of labour— that tends to cause wages (and other factor prices) to fall. Copyright © 2017 Pearson Canada Inc.

Downward Wage Stickiness 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. Copyright © 2017 Pearson Canada Inc.

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

24.3 Aggregate Demand and Supply Shocks Fig. 24-2 The Adjustment Process Following a Positive AD Shock Positive AD Shocks The increase in aggregate demand creates an inflationary gap. The adjustment in wages and other factor prices eventually eliminates the inflationary gap. The AS curve shifts leftward and real GDP returns to its potential level. (ii) Wage adjustment shifts AS Copyright © 2017 Pearson Canada Inc.

Negative AD Shocks Fig. 24-3 The Adjustment Process Following a Negative AD Shock The decrease in aggregate demand creates a recessionary gap. Unless factor prices are completely rigid, the AS curve eventually reaches AS1. After all adjustment has occurred, the eventual effect is to reduce the price level but leave real GDP unchanged. (ii) Wage adjustment shifts AS Copyright © 2017 Pearson Canada Inc.

Aggregate Supply Shocks Fig. 24-4 The Adjustment Process Following a Negative AS Shock The economy’s adjustment process reverses the AS shift and eventually returns the economy to its starting point. Copyright © 2017 Pearson Canada Inc.

Long-Run Equilibrium Following any AD or AS shocks, the adjustment of factor prices continues until real GDP returns to Y*. The economy is in long-run equilibrium when this adjustment process is complete and there is no longer an output gap. So the economy is in long-run equilibrium when the intersection of the AD and AS curves occurs at Y*. Copyright © 2017 Pearson Canada Inc.

Fig. 24-5 Changes in Long-Run Equilibrium In part (i), a shift in the AD curve raises the price level but leaves real GDP unchanged in the long run. In part (ii), an increase in potential output raises real GDP and lowers the price level. (i) A rise in aggregate demand (ii) A rise in potential output Copyright © 2017 Pearson Canada Inc.

24.4 Fiscal Stabilization Policy Fiscal stabilization policy is fundamentally a short-run policy. In response to various shocks, the government may use various fiscal tools in an attempt to push real GDP back towards potential output. The alternatives to using fiscal stabilization policy are to wait for the recovery of private-sector demand (a shift in the AD curve) or to wait for the economy’s adjustment process (a shift in the AS curve). Copyright © 2017 Pearson Canada Inc.

The Basic Theory of Fiscal Stabilization Fig. 24-6 The Closing of a Recessionary Gap A recessionary gap may be closed by a (slow) downward shift of the AS curve or an increase in aggregate demand. Copyright © 2017 Pearson Canada Inc.

Fig. 24-7 The Closing of an Inflationary Gap An inflationary gap may be removed by an upward shift of the AS curve or by a leftward shift of the AD curve. Copyright © 2017 Pearson Canada Inc.

Short Run Versus Long Run The paradox of thrift—the idea that an increase in saving reduces the level of real GDP—is true only 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. Copyright © 2017 Pearson Canada Inc.

Automatic Fiscal Stabilizers Suppose a shock shifts the AD curve to the right and increases the short-run level of real GDP. As real GDP increases, government tax revenues also increase. Now with fewer low-income households and unemployed persons requiring assistance, governments make fewer transfer payments to individuals. The rise in net tax revenues dampens the overall increase in real GDP caused by the initial shock. The tax-and-transfer system reduces the value of the multiplier and acts as an automatic stabilizer for the economy. Copyright © 2017 Pearson Canada Inc.

Automatic Fiscal Stabilizers 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 the net tax rate (t), the larger the simple multiplier and thus the less stable is real GDP in response to shocks to autonomous spending. Copyright © 2017 Pearson Canada Inc.

Fiscal Policy and Growth If an increase in government purchases leads to an increase in potential output (or its growth rate), the negative effects from the crowding out of private investment will be reduced. Reductions in tax rates generate a short-run demand stimulus and may also generate a longer-run increase in the level and growth rate of potential output. Copyright © 2017 Pearson Canada Inc.

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

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.