1. Chapter 24: From the Short Run to the Long Run: The Adjustment of Factor Prices
Copyright © 2014 Pearson Canada Inc.

2. Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
24.1 The Adjustment Process
explain why output gaps cause wages and other factor prices to change.
describe how induced changes in factor prices affect firms' costs and shift the AS curve.
24.2 Aggregate Demand and Supply Shocks
explain why real GDP gradually returns to potential output following an AD or AS shock.
24.3 Fiscal Stabilization Policy
understand why lags and uncertainty place limitations on the use of fiscal stabilization policy.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

3. The Adjustment of Factor Prices
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
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

4. 24.1 The Adjustment Process
Potential Output and the Output Gap
Fig Output Gaps in the Short Run
(i) A recessionary gap, Y < Y*
(ii) An inflationary gap, Y > Y*
Output Gap = Y - Y*
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

5. Factor Prices and the Output Gap
When Y > Y*, the demand for labour (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 labour
wages and unit costs tend to rise
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

6. recessionary output gap
When Y < Y*, the demand for labour (and other factor services) is relatively low
recessionary output gap
During a recessionary gap there are low profits for firms and low demand for labour
wages and unit costs tend to fall*
* assuming no inflation and productivity growth
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

7. Adjustment asymmetry:
inflationary output gaps typically raise wages rapidly
recessionary output gaps often reduce wages only slowly (downward wage stickiness)
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

8. Potential Output as an "Anchor"
Suppose an AD or AS 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
When Y = Y*, the unemployment rate equals NAIRU, U*.
there is both structural and frictional unemployment
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

9. 24.2 Aggregate Demand and Supply Shocks
Fig The Adjustment Process Following a Positive AD Shock
Expansionary AD Shocks
The economy's adjustment process eventually eliminates any boom caused by a demand shock, returning Y to Y*.
(ii) Wage adjustment shifts AS
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

10. Contractionary AD Shocks
Fig The Adjustment Process Following a Negative AD Shock
The economy's adjustment process works following negative demand shocks too.
although it may be slower because of "sticky wages"
(ii) Wage adjustment shifts AS
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

11. Aggregate Supply Shocks
After a negative supply shock, the adjustment of factor prices reverses the AS shift and returns real GDP to Y*.
Example: Consider an increase in the world price of some important
raw materials.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

12. It Matters How Quickly Wages Adjust!
Following either a demand or supply shock, the speed that output returns to Y* depends on wage flexibility. Flexible wages provide an adjustment process that quickly pushes the economy back toward potential output. But if wages are slow to adjust, the economy's adjustment process is sluggish and thus output gaps tend to persist.
EXTENSIONS IN THEORY 24-2
The Business Cycle: Additional Pressures for Adjustment
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

13. 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*
The vertical line at Y* is sometimes called:
the long-run aggregate supply curve, or
the classical aggregate supply curve
There is no relationship in the long run between the price level and potential output.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

14. Fig. 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
(i) A rise in aggregate demand
(ii) A rise in potential output
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

15. 24.3 Fiscal Stabilization Policy
The motivation for fiscal stabilization policy is to reduce the volatility of aggregate outcomes.
When an AD or AS shock pushes Y away from Y* the alternatives are:
use fiscal stabilization policy
wait for the recovery of private sector demand  a shift in the AD curve
wait for the economy's adjustment process  a shift in the AS curve
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

16. MyEconLab www.myeconlab.com
Though macroeconomists tend to focus on fluctuations in real GDP
when describing business cycles, there is no single "best" measure of the changes in economic activity. For a detailed description of several popular measures of changes in the level of economic activity—including GDP growth, housing starts, and capacity utilization—look for Several Measures of Economic Fluctuations in Canada in the Additional Topics section of this book's MyEconLab.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

17. The Basic Theory of Fiscal Stabilization
Fig The Closing of a Recessionary Gap
A recessionary gap may be closed by a (possibly slow) rightward shift in the AS curve or by a rightward shift in AD.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

18. Fig. 24-7 The Closing of an Inflationary Gap
An inflationary gap may be removed by a leftward shift of AS or by a leftward shift in AD.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

19. Fiscal Policy in the Great Depression
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!
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 does not apply in the long run.
LESSONS FROM HISTORY 24-1
Fiscal Policy in the Great Depression
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

20. Automatic vs. Discretionary Fiscal Policy
Discretionary fiscal stabilization policy occurs when the government actively changes G and/or T in an effort to steer real GDP.
Automatic fiscal stabilization occurs because of the design of the tax and transfer system:
as Y changes, transfers and taxes both change
the size of the simple multiplier is reduced
the output response to shocks is dampened
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

21. The marginal propensity to spend on national income is: z = MPC(1 – t) – m The simple multiplier is: Simple multiplier = 1/ (1 – z) The lower is the net tax rate (t), the larger is the simple multiplier and thus the less stable is real GDP in response to shocks to autonomous spending.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

22. Practical Limitations as Discretionary Fiscal Policy
Most economists agree that automatic fiscal stabilizers are desirable and generally work well, but they have concerns about discretionary fiscal policy.
Limitations come from:
long and uncertain lags
temporary versus permanent changes in policy
the impossibility of "fine tuning"
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide

23. Fiscal Policy and Growth
Fiscal stabilization policy will generally have consequences for economic growth.
An increase in G:
Increases Y in the short run
In the long run, the rate of growth of Y* may be:
lower if private investment is lower in the new long-run equilibrium.
higher if G increases the productivity of private-sector production.
A reduction in t:
There is no tradeoff between short and long run
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide