1. The Difference Between Short-Run and Long-Run Macroeconomics
Chapter 25
The Difference Between Short-Run and Long-Run Macroeconomics
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2. 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.
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3. 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.
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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?
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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.
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6. 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

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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
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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.
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9. 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

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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
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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.
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13. 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

14. 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?
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15. - 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

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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?
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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
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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.
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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*
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