1. of 241 Chapter 24 From the Short Run to the Long Run: The Adjustment of Factor Prices

2. of 242 Copyright © 2005 Pearson Education Canada Inc. Learning Objectives 1. Explain why wages and other factor prices change when there is an output gap. 3. Explain why output gradually returns to potential output following an aggregate demand or supply shock. 2. Explain how induced changes in factor prices affect firms’ costs and shift the AS curve. 4. Recognize how lags and uncertainty place limitations on the use of fiscal policy.

3. of 243 The Short Run The defining characteristics of the short run are: factor prices are assumed to be constant, and technology and factor supplies are assumed to be constant. When the economy has reached a short rum equilibrium, then The level of output (GDP or Y) and output prices (P) stop changing. But what is happening to factor prices? They are assumed to be fixed in the short run but do they remain fixed for ever? That depends!

4. of 244 Depending on whether or not the short run equilibrium level of output is equal to the potential level of output, factor prices might start to increase, decrease or they might remain constant. In the long run factor prices will change to ensure that factor market remain in equilibrium. The Adjustment of Factor Prices During the adjustment process, factor prices are assumed to be flexible, but technology and factor supplies are constant. The VERY Long Run In the long run, factor prices are assumed to have completely adjusted, and technology and factor supplies are assumed to be changing.

5. of 245 What causes factor price to start changing in the long run adjustment process? Output Gaps.

6. of 246 Copyright © 2005 Pearson Education Canada Inc. 24.1 Output Gaps and Factor Prices Potential Output and the Output Gap AS Y0Y0 AD Y* E0E0 Output gap AS Y1Y1 AD Y* E1E1 Output gap Output Gap = Y - Y* P Y Y P

7. of 247 Factor Prices and the Output Gap An Inflationary Output Gap When actual GDP exceeds potential GDP (Y>Y*), the demand for labour (and other factor services) is relatively high. The boom that is associated with an inflationary gap generates a set of conditions — high profits for firms and unusually large demand for labour — that causes wages and unit costs to rise. This might be true for many inputs, not just labour. It might not be true for labour but true for other key inputs.

8. of 248 When actual GDP is below potential (Y < Y*), the demand for labour (and other factor services) is relatively low. Speed of Factor-Price Adjustment The speed of factor-price adjustment depends on the situation — booms typically cause wages to rise rapidly, whereas slumps often cause wages to fall only slowly. The slump that is associated with a recessionary gap generates a set of conditions — low profits for firms and low demand for labour — that causes wages and unit costs to fall. Again this is likely true for other (all?) inputs.

9. of 249 Copyright © 2005 Pearson Education Canada Inc. Potential Output as an “Anchor” Following an aggregate demand or supply shock, the short- run equilibrium level of output may be different from potential output. As a result, wages and other factor prices will adjust, eventually bringing the equilibrium level of output back to potential. When Y = Y*, the unemployment rate equals the NAIRU, the natural rate of unemployment (denoted U*). U* includes both structural and frictional unemployment.

10. of 2410 Potential Output equal to Actual Output No Output Gap AS Y0=Y0= AD Y* E0E0 Output Gap = Y - Y* = 0 P Y Long run equilibrium AD = AS and output prices are not changing and factor prices are not changing Both the output markets and the factor markets are in equilibrium

11. of 2411 Potential Output equal to Actual Output No Output Gap AS Y0=Y0= AD Y* E0E0 P Y Does the economic system Always move towards a Long run equilibrium? How do we get to a long run equilibrium? All the action is in actor markets.

12. of 2412 24.2 Demand and Supply Shocks Expansionary AD Shocks AS 0 Y1Y1 AD 0 Y* E1E1 AD 1 E0E0 P1P1 P0P0 Step 1: the short run adjustment A positive demand shock first raises P and Y, causing an inflationary gap to open as the economy moves from E 0 to E 1 Inflationary gap opens Price level rises But now factor markets are ‘overheated’. There is greater than normal demand for factors and upward pressure on input prices. Y P

13. of 2413 Expansionary AD Shocks AS 0 Y1Y1 AD 0 Y* E1E1 AS 1 AD 1 E2E2 E0E0 P2P2 P1P1 P0P0 Step 2: the long run adjustment As input prices rise, the AS curve shifts back. The output gap begins to close as P increase further and Y falls. This continues until input prices stop increasing and input prices stop increasing when the economy has moved from E 1 to E 2, returning to Y* Inflationary gap closes Price level rises further This automatic adjustment mechanism eventually eliminates any boom caused by a demand shock by returning Y to Y*. The unusually ‘good times’ self-destruct. Y P

14. of 2414 Contractionary AD Shocks AS 0 Y1Y1 AD 1 Y* E1E1 AD 0 E0E0 P0P0 P1P1 Recessionary gap opens Price level falls Step 1: the short run adjustment A negative demand shock first reduces P and Y, causing a recessionary output gap to open as the economy moves from E 0 to E 1 P Y But now factor markets are ‘slack’. There is less than normal demand for factors and downward pressure on input prices.

15. of 2415 Contractionary AD Shocks AS 0 Y1Y1 AD 1 Y* E1E1 AS 1 AD 0 E2E2 E0E0 P2P2 P0P0 P1P1 Recessionary gap closes Price level falls further Step 2: the long run adjustment As input prices fall, the AS curve shifts out. The output gap begins to close as P falls further and Y increases. This continues until input prices stop falling when the economy has moved from E 1 to E 0, returning to Y * P Y The automatic adjustment mechanism eventually eliminates the recessionary gap caused by the negative demand shock. IN THEORY!

16. of 2416 Aggregate Supply Shocks AS 0 Y1Y1 AD Y* E1E1 AS 1 E0E0 P1P1 P0P0 Recessionary gap opens Price level rises Recessionary gap closes Price level falls A negative supply shock causes Y to fall and P to rise. The adjustment of factor prices then reverses the AS shift and returns the economy to its starting point. Y P Example: Consider an increase in the world price of some important raw materials.

17. of 2417 Wages that are flexible — and thus change rapidly during output gaps — provide an automatic adjustment mechanism that pushes the economy back toward potential output. But if wages are sticky or rigid, the economy’s adjustment mechanism is sluggish and thus output gaps tend to persist. It Matters how Quickly Wages Adjust! Following either a demand or supply shock, the speed at which the economy returns to Y* depends on the amount of wage flexibility. The US and Canada versus Germany and much of Western Europe - strong labour unions - legislation

18. of 2418 Copyright © 2005 Pearson Education Canada Inc. Economic Shocks and Business Cycles Both aggregate demand and aggregate supply are subject to continual random shocks. The economy’s automatic adjustment mechanism converts these shocks into cyclical fluctuations in real GDP. Because of the significant lags in the economy’s responses to these shocks, changes in output are drawn out over substantial periods of time.

19. of 2419 Copyright © 2005 Pearson Education Canada Inc. Long-Run Equilibrium The economy is in a state of long-run equilibrium when factor prices are no longer adjusting to output gaps. In other words, full employment of factors will prevail, and output will be at its potential level, Y*. This curve is vertical because there is no relationship in the long run between the price level and the amount of output that the economy can produce under full employment. The vertical line (P,Y) that depicts potential output is sometimes called the long-run aggregate supply curve, or the Classical aggregate supply curve.

20. of 2420 AD 0 Y0*Y0* E1E1 AD 1 E0E0 P1P1 P0P0 In the long run, Y is determined only by potential output — aggregate demand determines P. Whatever short run shocks occur, once the long run adjustment is complete the economy ends up back at Y *. This is the potential level of output given the current technology and supply of factors. P Y

21. of 2421 AD 0 Y0*Y0* E1E1 E0E0 P1P1 P0P0 Y1*Y1* AD 0 Y0*Y0* E1E1 E0E0 P0P0 P1P1 However, if technology were to improve and/or factor supplies were to increase, than the economies potential output would increase. The result would be more output and lower prices. This is long run economic growth. Could an economy ever suffer long run economic decline? Certainly, war revolution, AIDS, etc. There are many possible causes of technological decline and/or decreased factor supplies P Y P Y Y1*Y1*

22. of 2422 Copyright © 2005 Pearson Education Canada Inc. 24.3 Fiscal Policy and the Business Cycle AD 0 Y* AD 1 AD 0 Y* AS 0 AS 1 AS Y1Y1 Y1Y1 In the short run, the economy is in equilibrium where the AD curve intersects the AS curve. Y P P Y Demand ShockSupply Shock

23. of 2423 Copyright © 2005 Pearson Education Canada Inc. In the long run, the economy is in equilibrium at Y = Y*, the position of the vertical Y* curve. Real GDP AD Y* 0 Price Level Y* 3 Y* 2 Y* 1 In the long run, only changes in the level of Y* can change the level of real GDP. The price level is determined where the AD curve intersects potential output.

24. of 2424 The Basic Theory of Fiscal Stabilization AD 0 Y* AD 1 AD Y* AS 0 AS 1 AS Y0Y0 Y0Y0 P0P0 P1P1 P0P0 P1P1 E1E1 E0E0 E1E1 E0E0 A recessionary gap may be closed by a rightward shift in AD (increase in G or decrease in T) or by a (possibly slow) rightward shift in the AS curve. Y PP Y

25. of 2425 AD 0 Y* AD 1 AD Y* AS 0 AS 1 AS Y0Y0 Y0Y0 P0P0 P1P1 P0P0 P1P1 E1E1 E0E0 E1E1 E0E0 An inflationary gap may be removed by a leftward shift in AD (a decrease in G or an increase in T) or by a leftward shift of AS. When the economy’s adjustment mechanism is slow to operate, there is a potential stabilizing role for fiscal policy. P YY P

26. of 2426 Copyright © 2005 Pearson Education Canada Inc. As real GDP rises, tax revenues rise, and this reduces expenditure, dampening the increase in GDP. As real GDP falls, tax revenues fall, and this increases expenditure, dampening the fall of real GDP. Discretionary fiscal policy occurs when the government decides to change G and/or T in an effort to change real GDP. Discretionary fiscal policy is reflected in a shift of the AD curve. Automatic vs. Discretionary Fiscal Policy The upward slope of the budget surplus function means that there are fiscal effects that cause the tax-and-transfer system to act as an automatic stabilizer for the economy.

27. of 2427 Copyright © 2005 Pearson Education Canada Inc. long and uncertain lags - Do we really know how fast these adjustments occur? temporary versus permanent changes in policy, and the impossibility of “fine tuning” - How precisely can we determine the effects of the changes in G or T Issues concerning the limitations of discretionary fiscal policy are: Most economists agree that automatic fiscal stabilizers are desirable and generally work well, but they have concerns about discretionary fiscal policy. Limitations of Discretionary Fiscal Policy

28. of 2428 Fiscal Policy and Growth The desirability of using fiscal policy to stabilize the economy depends a great deal on the speed with which the economy’s automatic adjustment mechanism returns the economy to potential output. Fiscal stabilization policy will generally have consequences for economic growth: an increase in G temporarily increases real GDP, investment is lower in the new long-run equilibrium, and this may reduce the rate of growth of potential output.

29. of 2429 Copyright © 2005 Pearson Education Canada Inc. The paradox of thrift (the idea that an increase in saving reduces the level of real GDP) is only true in the short run, when the level of aggregate demand is relevant for determining real GDP. In the long run, an increase in desired saving has the following effects: the price level falls, investment rises, and output returns to its potential level. The Paradox of Thrift

30. of 2430