Chapter 8 Long Run Macroeconomics – The Self Correcting Economy

Long Run Period where wage contracts and resource prices are flexible

Expansionary Gap Expansionary Gap = Actual GDP > Natural (Potential) GDP (inflationary) – AD or AS shifts to the right causing the gap – Overemployment exists Overtime work, Greater than capacity capital use, labor in short supply – As wage contracts end they are renegotiated at a higher rate Wages rise – Costs rise for firms – Firms produce less – SRAS shifts to the left to the Potential GDP – Incomes fall

Contractionary Gap – Contractionary Gap = Actual GDP < Natural (Potential) GDP (unemployment) AD or AS shifts to the right causing the gap Unemployment exists – Idle workers, lower than capacity capital use, labor in great supply As wage contracts end they are renegotiated at a lower expected inflation rate – Wages fall Costs fall for firms Firms produce more SRAS shifts to the right to the Potential GDP Incomes began to rise

Long Run Aggregate Supply (LRAS) Vertical at the Potential GDP Outward shift in the PPC causes the LRAS to shift leftward Long Run Equilibrium – Actual Price level = Expected Price level – Actual GDP = Potential GDP – Qs = Qd – Long Run Aggregate Supply is Vertical at the Potential GDP, no price surprises

Problems Wages don’t decrease but they do Takes to long to self-correct (6 years)