15-1 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Modern Macroeconomics: From the Short Run to the Long Run Brock Williams P R E P A R E D B Y Just prior to the start of the December 2007 recession, unemployment stood at 4.7 percent. It rose to over 10 percent in CHAPTER 15 Copyright © 2012 Pearson Prentice Hall. All rights reserved.

15-3 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run 1 2 What steps can policymakers take to deal with a possible liquidity trap? Avoiding a Liquidity Trap What are the links between presidential elections and macroeconomic performance? Elections, Political Parties, and Voter Expectations Will increases in health-care expenditures crowd out consumption or investment spending? Increasing Health-Care Expenditures and Crowding Out 3 A P P L Y I N G T H E C O N C E P T S

15-4 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 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 15.1 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 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: 1How does what happens in the short run determine what happens in the long run? 2How long is the short run?

15-5 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run LINKING THE SHORT RUN AND THE LONG RUN (cont’d) 15.1 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. R E A L - N O M I N A L P R I N C I P L E What matters to people is the real value of money or income—its purchasing power—not its “face” value.

15-6 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT 15.2 ● aggregate demand curve A curve that shows the relationship between the level of prices and the quantity of real GDP demanded. 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. 1Aggregate demand. 2Aggregate 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.

15-7 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (cont’d) 15.2 Returning to Full Employment from a Recession  FIGURE 15.1 How the Economy Recovers from a Downturn 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.

15-8 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run Returning to Full Employment from a Boom  FIGURE 15.2 How the Economy Returns 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. HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (cont’d) 15.2

15-9 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run 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. HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (cont’d) 15.2

15-10 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run Economic Policy and the Speed of Adjustment  FIGURE 15.3 Using Economic Policy to Fight a Recession Rather than letting the economy naturally return to full employment at point b, economic policies could be implemented to increase aggregate demand from AD 0 to AD 1 to bring the economy to full employment at point c. The price level within the economy, however, would be higher. HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (cont’d) 15.2

15-11 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run Fed Chairman Ben Bernanke became concerned when the federal funds rate fell below 0.5 percent in What could be done to avoid a liquidity trap? One way was to commit to higher inflation in the future. Although nominal interest rates cannot go below zero, real interest rates could. However, the Fed is responsible for maintaining low interest rates, so this is not an ideal policy. Instead, the Fed began paying interest rates on bank reserves. Since banks could earn a minimum interest rate with deposits, this effectively put a floor on interest rates. AVOIDING A LIQUIDITY TRAP APPLYING THE CONCEPTS #1: What steps can policymakers take to deal with a possible liquidity trap? A P P L I C A T I O N 1

15-12 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run 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. Political Business Cycles HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (cont’d) 15.2

15-13 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run The original political business cycle theories focused on incumbent presidents trying to manipulate the economy in their favor to gain reelection. 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 ELECTIONS, POLITICAL PARTIES, AND VOTER EXPECTATIONS APPLYING THE CONCEPTS #2: What are the links between presidential elections and macroeconomic performance? A P P L I C A T I O N 2

15-14 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS 15.3 R E A L - N O M I N A L P R I N C I P L E What matters to people is the real value of money or income—its purchasing power—not its “face” value.

15-15 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run  FIGURE 15.4 How the Changing Price Level Restores the Economy to Full Employment 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. UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS 15.3

15-16 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run 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. UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS (cont’d) 15.3

15-17 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run The Long-Run Neutrality of Money  FIGURE 15.5 Monetary Policy in the Short Run and the Long Run As the Fed increases the supply of money, the aggregate demand curve shifts from AD 0 to AD 1 and the economy moves to point a. In the long run, the economy moves to point b. UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS (cont’d) 15.3

15-18 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run The Long-Run Neutrality of Money  FIGURE 15.6 The 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. UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS (cont’d) 15.3

15-19 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run 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. UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS (cont’d) 15.3

15-20 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run Crowding Out in the Long Run  FIGURE 15.7 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. UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS (cont’d) 15.3

15-21 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run 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. INCREASING HEALTH-CARE EXPENDITURES AND CROWDING OUT APPLYING THE CONCEPTS #3: Will increases in health-care expenditures crowd out consumption or investment spending? A P P L I C A T I O N 3

15-22 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run CLASSICAL ECONOMICS IN HISTORICAL PERSPECTIVE 15.4 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 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.

15-23 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 15 Modern Macroeconomics: From the Short Run to the Long Run 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 K E Y T E R M S