The Difference Between Short-Run and Long-Run Macroeconomics Chapter 25 The Difference Between Short-Run and Long-Run Macroeconomics Copyright © 2011 Pearson Canada Inc.

In this chapter you will learn… 1. …why economists think differently about short-run and long-run changes in macroeconomic variables. 2. …that any change in real GDP can be decomposed into changes in factor supply, the utilization rate of factors, and productivity. Copyright © 2011 Pearson Canada Inc.

In this chapter you will learn… 3. …why short-run changes in GDP are mostly caused by changes in factor utilization, whereas long-run changes in GDP are mostly caused by changes in factor supplies and productivity. 4. …that macroeconomic policies will only have a long-run effect on output if they influence factor supplies or productivity. Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc. 25.1 Two Examples from Recent History Inflation and Interest Rates in Canada Ceteris paribus, an increase in inflation pushes up nominal interest rates. The Bank of Canada argues that: in order to reduce inflation and interest rates, the Bank must take actions which raise the interest rate immediately. How can this be sensible? Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc. The key to this puzzle: - recognize the different short-run and long-run effects of monetary policy In the short run, the rise in interest rates causes aggregate expenditure to fall, reducing output. But in the long run, the downward pressure on wages (recessionary gap) causes inflation to fall, and interest rates too. Copyright © 2011 Pearson Canada Inc.

As interest rates increase C and I decrease causing AD to shift in but this negative demand shock causes a recession which means wages rise more slowly than productivity and AS shifts out (positive supply shock) P AS0 AS1 Both the negative demand shock and the positive supply shock cause P to decrease In the longer run we end up back at Y* but with lower prices (at least a lower rate of price increases). P0 • E0 P1 • E1 AD0 • E2 AD1 Y1 Y* Y MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

Copyright © 2011 Pearson Canada Inc. Saving and Growth in Japan For the decade following 1990, Japan’s economy was stagnant. Some argue there was too much saving (and too little spending). Many also argue that Japan’s economic success since World War II was due in part to its high saving rate. How can both views be correct? - recognize the different short-run and long-run effects of saving Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc. In the short run, an increase in desired saving leads to less aggregate desired spending  economic slump. But in the long run, greater saving expands the pool of funds, drives down interest rates, and makes investment more attractive. More investment in capital leads to increases in the economy’s long-run productive potential  economic growth. Copyright © 2011 Pearson Canada Inc.

Recall increases in the desired Savings of households In the long run the increase in S (decrease in C) will result in an increase in I and a shift out in Y* P Much of this happens through changes in r which we will study later The higher short run Savings lead to greater Investment and growth in long run supply - increase in Y* to Y** AS1 P0 • E0 • E2 P1 • E1 AD0 AD1 Y1 Y* Y** Y MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

Copyright © 2011 Pearson Canada Inc. A Need to Think Differently Short run: - emphasize changes in output as deviations from potential - limited price and wage adjustment Long run: - emphasize changes in output as changes of potential - considerable wage and price adjustment takes place Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc. 25.2 Accounting for Changes in GDP GDP Accounting: The Basic Principle GDP = GDP must be true GDP = F/F x GDP must be true since F/F =1 GDP = F/F x FE/FE x GDP must be true since FE / FE =1 But we can re-arrange terms so that, GDP = F x (FE/F) x (GDP/FE) • F is the amount of factors • FE is the amount of employed factors. Copyright © 2011 Pearson Canada Inc.

Optional proof GDP = GDP must be true GDP = F/F x GDP must be true since F/F =1 GDP = F/F x FE/FE x GDP must be true since FE / FE =1 But we can continue so that, GDP = F/F[(F/F) x (FE/FE) x (GDP)] must be true since F/F =1 GDP =[F x (FE/FEF) x (GDP)] re-arranging GDP =FE/FE[(F) x (FE/FEF) x (GDP)] must be true since FE / FE =1 GDP = [(F) x FE(FE/FEF) x (GDP/FE)] re-arranging Finally, GDP = F x (FE/F) x (GDP/FE) MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

GDP = F x (FE/F) x (GDP/FE) What are the three separate terms? 1. F is the factor supply. 2. FE/F is the factor utilization rate. 3. GDP/FE is a simple measure of productivity. Any change in GDP must be associated with a change in one or more of these things. How do these three components change over time? Copyright © 2011 Pearson Canada Inc.

- supplies of labour and capital change only gradually 1. Factor Supplies - supplies of labour and capital change only gradually labour – population growth, immigration, higher participation rates) capital – more investment 2. Productivity - productivity changes only gradually improved labour – healthier, better trained and educated improved capital – embodied technical change improved technology – disembodied technical change 3. Factor Utilization Rate – output gap as a percentage of Y* (Y-Y*)/Y * 100 - fluctuates a lot in the short run - fluctuates very little in the long run MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

Copyright © 2011 Pearson Canada Inc. GDP Accounting: An Application Consider just one factor of production — labour. The identity becomes: GDP = L x (E/L) x (GDP/E) - L is the labour force - E/L is the employment rate - GDP/E is a simple measure of labour productivity How have these components actually moved in Canada? Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc. Summing Up To understand long-run changes in GDP: - need to understand labour force growth and productivity growth To understand short-run changes in GDP: - need to understand changes in the utilization rate of labour — the employment rate Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc. Canada and many other developed economies experienced a “productivity slowdown” in the early 1970s. And in recent years, many economists have expressed concern about Canada’s slow rate of productivity growth compared to that of its major trading partners, especially the United States. For more information on Canada’s recent productivity performance, and what can be done about it, look for Understanding and Addressing Canada’s Productivity Challenges in the Additional Topics section of this book’s MyEconLab. www.myeconlab.com Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc. 25.3 Policy Implications Fiscal and monetary policies affect the short-run level of GDP because they alter the level of aggregate demand. But unless they are able to affect the level of potential output, they will have no effect on long-run GDP. - broad consensus that monetary policy has only limited effects on Y* - fiscal policy probably has more effects on Y* Copyright © 2011 Pearson Canada Inc.

Copyright © 2011 Pearson Canada Inc.