Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 24 From the Short Run to the Long Run: The Adjustment of Factor Prices

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1. Explain why output gaps cause wages and other factor prices to change. 3. Explain why real GDP gradually returns to potential output following an AD or AS shock. 2. Describe how induced changes in factor prices affect firms’ costs and cause the AS curve to shift. 4. Explain why lags and uncertainty place limitations on the use of fiscal stabilization policy.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 The Short Run and the Long Run

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 24.1 Time Spans in Macroeconomic Analysis

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 24.1 Output Gaps in the Short Run Potential Output and the Output Gap

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Factor Prices and the Output Gap When Y > Y*, the demand for labor (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 labor: - wages and unit costs tend to rise

Copyright © 2008 Pearson Addison-Wesley. All rights reserved When Y < Y*, the demand for labor (and other factor services) is relatively low: - recessionary output gap During a recessionary gap there are low profits for firms and low demand for labor - wages and unit costs tend to fall (assuming no inflation and productivity growth) Factor Prices and the Output Gap

Copyright © 2008 Pearson Addison-Wesley. All rights reserved This general adjustment process — from output gaps to factor prices — is summarized by the Phillips curve. Adjustment asymmetry: - inflationary output gaps typically raise wages rapidly - recessionary output gaps often reduce wages only slowly Factor Prices and the Output Gap

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 labor => wages rise Y excess supply for labor => wages fall Y = Y* => no excess supply/demand => wages constant EXTENSIONS IN THEORY 24.1 The Phillips Curve and the Adjustment Process The Phillips Curve

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Potential Output as an “Anchor” Suppose an AD or AD 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

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 24.2 The Adjustment Process Following a Positive Aggregate Demand Shock

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 24.3 The Adjustment Process Following a Negative Aggregate Demand Shock

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 24.4 The Adjustment Process Following a Negative Aggregate Supply Shock Aggregate Supply Shocks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Flexible wages provide an adjustment process that quickly pushes the economy back toward potential output. But if wages are slow to adjust (sticky), the economy’s adjustment process is sluggish and thus output gaps tend to persist. It Matters How Quickly Wages Adjust! Following either a demand or supply shock, the speed with which output returns to Y* depends on wage flexibility.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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* There is no relationship in the long run between the price level and potential output. The vertical line at Y* is sometimes called: - the long-run aggregate supply curve - the Classical aggregate supply curve

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 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.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Fiscal Stabilization Policy The motivation for fiscal stabilization policy is to reduce the volatility of aggregate outcomes. The Basic Theory of Fiscal Stabilization A reduction in tax rates or an increase in government purchases shifts the AD curve to the right, causing an increase in real GDP. An increase in tax rates or a cut in government purchases shifts the AD curve to the left, causing a decrease in real GDP.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 24.6 The Closing of a Recessionary Gap

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 24.7 The Closing of an Inflationary Gap

Copyright © 2008 Pearson Addison-Wesley. All rights reserved 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 In the short run, an increase in desired saving leads to a reduction in GDP — and possibly no change in aggregate saving!

Copyright © 2008 Pearson Addison-Wesley. All rights reserved LESSONS FROM HISTORY 24.1 Fiscal Policy in the Great Depression The Great Depression

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Discretionary fiscal stabilization policy occurs when the government actively changes G and/or T in an effort to affect real GDP. Automatic vs. Discretionary Fiscal Policy Automatic fiscal stabilization occurs because of the design of the tax and transfer system (T = tY): - as Y changes, transfers and taxes both change - reduces the size of the simple multiplier - dampens the output response to shocks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved long and uncertain lags temporary versus permanent changes in policy the impossibility of “fine tuning” Limitations come from: Most economists agree that automatic fiscal stabilizers are desirable and generally work well, but they have concerns about discretionary fiscal policy. Practical Limitations of Discretionary Fiscal Policy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved decision lag – time between perceiving the problem and reaching a decision execution lag – time to put policies in place after a decision has been made Policy Lags Temporary versus Permanent Tax Changes tax changes expected to be temporary are less effective than those expected to be permanent

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Role of Discretionary Fiscal Policy Fine tuning is the use of policy to offset virtually all fluctuations in private-sector spending in order to keep real GDP at or near its potential level. Fine tuning is difficult. Nevertheless, many economists still argue that when an output gap is large and persistent enough, gross tuning may be appropriate.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Fiscal Policy and Growth Fiscal stabilization policy will generally have consequences for economic growth. For example: an increase in G temporarily increases real GDP investment is lower in the new long-run equilibrium this may reduce the rate of growth of potential output