Download Output Gap = Y

Chapter 24:
From the Short Run
to the Long Run:
The Adjustment of
Factor Prices
Copyright © 2014 Pearson Canada Inc.
Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
24.1 The Adjustment
Process
1.
explain why output gaps cause wages and other factor
prices to change.
2.
describe how induced changes in factor prices affect
firms' costs and shift the AS curve.
24.2 Aggregate Demand
and Supply Shocks
3.
explain why real GDP gradually returns to potential
output following an AD or AS shock.
24.3 Fiscal Stabilization
Policy
4.
understand why lags and uncertainty place limitations
on the use of fiscal stabilization policy.
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide 2
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 3
24.1 The Adjustment Process
Potential Output and the Output Gap
Fig. 24-1
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 4
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 5
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 6
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 7
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 8
24.2 Aggregate Demand and Supply Shocks
Expansionary AD Shocks
The economy's adjustment
process eventually
eliminates any boom
caused by a demand
shock, returning Y to Y*.
Fig. 24-2
The Adjustment
Process Following
a Positive AD Shock
(ii) Wage adjustment shifts AS
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide 9
Contractionary AD Shocks
Fig. 24-3
The economy's adjustment
process works following
negative demand shocks
too.
The Adjustment
Process Following
a Negative AD Shock
• although it may be
slower because of
"sticky wages"
(ii) Wage adjustment shifts AS
Copyright © 2014 Pearson Canada Inc.
Chapter 24, Slide 10
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 11
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 12
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
Copyright © 2014 Pearson Canada Inc.
(i) A rise in aggregate demand
(ii) A rise in potential output
Chapter 24, Slide 13
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 14
The Basic Theory of Fiscal Stabilization
Fig. 24-6
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 15
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 16
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 17
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 18
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 19
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 20