Download Macroeconomics: Long Run and Short Run

Economics for Educators
Lesson 16 and 5E Model
Revised Edition
Robert F. Hodgin, Ph.D.
Texas Council on Economic Education
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Economics for Educators, Revised
Copyright © 2012
Texas Council on Economic Education
All Rights Reserved
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Lesson 16: Macroeconomics: Long Run and Short Run
Macroeconomic Goals
Attempts to resolve the nation’s economic problem underscore the need to make real trade-offs in the macro economy. What goals
should an economy pursue to best address the economic problem? The Employment Act of 1946, passed in response to the Great
Depression, set forth the government’s commitment to maintain full employment. That act also established the Council of Economic
Advisors, an appointed body of economists, who to this day provide policy counsel to US presidents.
Macroeconomic Goals
9 Full employment
9 Stable prices
9 Steady growth
9 Stable interest rates
Pursuing these goals also reveals policy conflicts that cannot be resolved without sacrifice. The federal government itself must
recognize the trade-offs for the economy as it passes legislation to either stimulate or restrain market forces. The essential question
is just how does the macroeconomy work? Economists have sought for over two centuries to understand the nature and functions of
a market economy through its two basic forces—demand and supply.
The theoretical question is whether and how a) supply creates the income to equal demand or b) demand generates enough
expenditure volume to purchase the supply? The debate has two major sub-parts: 1) what forces motivate change in economic
actions and 2) do macro-markets adjust for the short run or the long run? Despite disagreements on each of these questions, the
majority of mainstream economists accept as true the following statements about macroeconomics.
Accepted Truths About Macroeconomics
9 Money volume is a “stock”, and income is a “flow”
9 The money stock is a fraction of total national income generated in any year
9 People have a demand for liquidity—to hold part of their wealth as money
9 One person can alter the money they hold by altering their own current expenditures, but
all persons in a society cannot alter the money they hold without macro consequences
9 As their wealth increases, people tend to spend more current income, and the opposite is true
9 A nation can make new economic investments only up to the level of its current savings
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The Long Run and Short Run
Mainstream macro economists accept that the Classical economists’ view of two centuries on how the economy works is correct in
the long run. Inspect the graph below to see what that means, in terms of aggregate demand (the down sloping green curve) and
aggregate supply (the curved upward red curve). In the long run—perhaps several years—the economy tends to adjust into
equilibrium at or near full employment—the vertical dark line in the graph. That happens because the production of real GDP
ultimately depends on the supply of labor, capital and natural resources. Once at full employment and equilibrium, the price level then
depends only on the volume of money in the system—and the central bank can influence the growth of the money supply to maintain
price stability.
Aggregate demand [AD]—a down sloping line that shows the quantity of GDP demanded [the sum of household
consumption (C), business investment (I), government spending (G) and foreign customers (NE = Net Exports)] purchased at
each price level.
Aggregate Supply [AS]—an up sloping line that shows the quantity of goods and services businesses choose to produce
and sell at each price level. In symbols: Aggregate Supply is a function of Labor, Capital, Land and Technology.
The economy’s “real” economic variables—production and employment (human activity and goods production)—are most
important. The “nominal” economic variables—those measured in money or percentage terms: prices, wages and interest rates,
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serve as facilitating signals to help determine the quantities of the real variables utilized in the economy. During normal times
adjustments in prices, wages and interest rates—the nominal variables—work to bring the production and employment—the real
variables—to full employment, the “natural” state for an economy in the long run.
It is in the short run where reality is messiest and debate is hottest. See the down sloping green AD1 line in the graph above and note
that where it crosses the ASShort Run real GDP is well below the full employment level of GDP. That means there is a large percentage
of unemployed workers. Misperceptions and uncertainty about the future by both consumers and business leaders abound. When
the economy goes awry, a mismatch between desired investment and actual savings sends the economy reeling. During this phase
both the price level and average wages adjust rather slowly, adding to future uncertainty about the economy. The natural human
instinct during times of strife is to pull back. At worst, a downward cycle of falling consumption and investment reduces aggregate
demand at any price level, shifting it to the left.
If the economy slips too far, the societal pain calls for aggregate demand stimulus from government. Economists and policy makers
seek to bolster aggregate demand through policies like: increased government spending (financed through public borrowing),
reduced federal income tax rates, and investment tax credits for business. The Federal Reserve System also may increase the
money supply to lower interest rates and stimulate borrowing by households and businesses.
The Equation of Exchange
Classical economic thought bears a relationship to what is called the “equation of exchange.” The formula has held an important
position in macroeconomic analysis for 200 years. We treat it here to motivate discussion on the role of money in determining
nominal (current dollar) GDP. Given the definitions below, the two sides of the relationship are identities. In other words, the money
stock (M1) times the number of times the stock is spent (V for “velocity”) must equal the real GDP (Q) times the average price level
(P). In short, the money stock times its expenditure “turnover” must equal goods produced times their average price.
Equation of exchange: M ˜ V = P˜ Q, the relationship between money, prices and goods production where:
M = quantity (stock) of money in circulation (here, M1),
V = velocity of money, the average number of times the money stock is spent in a year to buy new goods and services,
P = average price level for goods and services,
Q = physical quantity of goods and services produced in one year = real GDP, and P ˜ Q = nominal GDP.
It is “V” that holds the greatest interest for economists. It measures, indirectly, the public’s demand to hold money. V is very stable
over time, though it is not constant. The reason is that the public’s desire to hold some of their wealth in the form of liquid money
varies with swings in the economy and their mood concerning future economic expectations. Consumers and businesses play a
crucial role determining the actual amount of the money stock and that makes monetary policy an art form. For example, if the
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Federal Reserve moves to increase the money supply to stimulate the economy but citizens absorb the increase by holding more
money than usual instead of spending it, they unwittingly undermine the Fed’s policy objective.
The household sector’s response to money supply variations becomes difficult to forecast when economic times are uncertain. This
is so because holding money has two costs: a) the lost opportunity of interest return on an investment and b) the prospect that in
times of inflation, the asset named money is losing value. Add to this the tendency for effects from changes in the money supply to
take effect from 12 to 18 months after a policy change, and the usefulness of monetary policy in periods of recession is limited.
The Multiplier
Though it may appear to non-economists as sleight-of-hand, $100 of new spending actually generates more than $100 in GDP. This
phenomenon occurs in a manner not visible to individuals. In short, expenditures that initiate new economic activity are re-spent
more than once, though by different people, as businesses along the production chain work to replenish inventories and workers
receive additional income to spend.
Multiplier–-The effect of additional spending from an initial spending stimulus from either the private sector (consumption or
investment) or the public sector (government spending or government taxes).
Suppose that the auto makers in Detroit determine that the next year is going to be less robust than originally forecast, so they
reduce their orders for new cars by $5 billion. Call this the initial shock. Recall that GDP measures production or income and it will
not fall simply due to a reduction in automobile orders. What will happen is that the automakers’ collective $5 billion reduction in
investment will cause manufacturers to add $5 billion of unsold cars to their inventories, an unanticipated investment. Now the
manufacturers are stuck holding $5 billion more in unsold car inventory than they desire and they will take steps to reduce it. How?
The manufacturers cut future orders by $5 billion in new car production. They lay off workers, idle plants and reduce purchases from
suppliers. Subsequently, the suppliers will have to cut back their planned activity and they will move to reduce their own inventories.
Once these reactions ripple from the original decision to reduce production and work their way through the supply chain, GDP also
will have fallen by $5 billion. Call this the industry chain reaction part of the multiplier. But the economic reverberations do not end
there.
Workers now have less money to spend due to the production decline. Less personal income means less expenditure for personal
consumption. If consumers behave according to their usual habits, additional consumption will fall by some fraction of the $5 billion.
For example, local shops and restaurants, auto dealers and clothiers notice a fall in store patronage and average customer purchase
amounts. Consequently, non-automobile industry inventories also experience unexpected excess supply building up and they, too,
take steps to reduce their unwanted inventories. Call this the household sector part of the multiplier. So the effect of one industry’s
lower expectations of the future and related adjustment comes to be “multiplied” throughout the economy.
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Multipliers work in both directions; enhancing the effect of both spending increases and spending decreases. The multiplier effect
from re-spending rounds to accommodate inventory changes moves the Aggregate Demand curve from its original position to its final
position. Multipliers take a year or two to work out. Any new spending change from any sector: households, businesses or
government, has an associated multiplier. The economy enjoys the multiplier’s power when spending is on the rise but also must
suffer the contraction impact when spending levels fall.
In Sum
9 Economists agree on certain economic goals, but they cannot all be met simultaneously without the government making
trade-offs: Full employment, Stable prices, Steady growth, Stable and low interest rates
9 Most mainstream economists accept the following beliefs about the macro economy
o Most people have a demand for liquidity—holding money
o One person can change (increase or decrease) the money they hold by reducing or increasing their expenditures.
o All persons in the economy cannot alter the money they hold without consequences.
o Households make the choice to consume or save their income based on their personal needs and future outlook.
o Businesses make the decision to borrow for investment based on the interest rate and the future business outlook.
o Business can make new investments only up to the level of current savings in the economy.
9 The debate on how the economy works centers on what how the economy adjusts in the short run versus the long run.
9 The multiplier represents the additional spending generated to reduce or replenish inventories from spending changes in any
sector.
9 The equation of exchange is: M˜V = P˜Q
o Where M = M1 (money stock), V = velocity, P = average price level and Q = GDP output
o The equation shows how the money supply directly affects nominal GDP
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The nature of the free market system is to have ups and downs which
are called business cycles. These unstable periods are the “short run”
and last for a few months or a few years. The overall economic trend is
what occurs in the long run – it is the “big picture” over a longer time
period. Overall, in U.S. history, the economy has been growing and
improving, leading to better standards of living for most people. The
long run goal is to continue that positive trend.
Discuss answers until you can “guide” students to discover that the
economy’s goal is to be at a level of equilibrium where demand and
supply are balanced at the maximum level of production for the
resources available, which is called “full employment.”
Why do you think that economists talk about “long run” and “short run”
when describing the overall “macroeconomy”?
What would the overall GOAL be for the nation’s economy?
Explore
The ultimate goal is to have a fulfilling and successful life. (This can be
described many ways).
Long term goals should include decisions on where to live, what
courses to take in high school to prepare for college, how to save
money & prepare to pay for college, when to marry, careers to pursue,
etc.
Students should come up with short term goals like: new clothes when
outgrowing the old, what to eat for dinner tonight, what to do for fun
this weekend, etc.
What is your ultimate goal?
In your life so far, what kind of decisions have been made for short term
goals, what are examples of decisions for long term goals?
Engage
Lesson 16: Macroeconomics: Long Run and Short Run, page 89
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How do you
Where does this
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Is the change in AD equal to the change in government spending? Why
not?
What does an increase in government spending do?
money go?
If the AD curve is shifting left due to recession and the public demands help
from the government, what might happen? What can the government do?
What changes on the graph?
What would cause a “long run” change?
Where would the goal be on this model?
Would these drawings be of the “short run” or “long run”?
know?
Extend
Demonstrate the drawing of the AD/AS graph, showing how changes in
AD (spending of C, G, Ig & Xn) change the GDP levels and prices levels.
The AD/AS graph illustrates how demands for expenditures affect the
price levels and the production levels (GDP).
A model is a drawing that illustrates what forces are leading to changes
in a measurable way.
Instruct students to copy the AD/AS graphs that you are drawing for them
to see.
How do models help explain the “big picture” of the economy?
What would be used to describe economic activity in a set time period?
Explain
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No – a set amount of government spending is multiplied by the velocity
of spending it over and over.
Money goes to consumers & workers who will then spend it for their
needs – creating income for others. As the money is spent over and
over, it acts like a multiplied amount, which is known as velocity of
money.
Money is increased for things like unemployment compensation and
new road building projects, for example.
Illustrate how this would work on a AD/AS graph. (Start with AD in the
left and flat stage of AS, then shift to the right into the upward sloping
AS.)
The government can make a policy decision to increase or decrease
government taxes or spending to force AD to shift to the right.
These changes require building new factories or businesses (or closing
them), installing new equipment and other major and permanent
changes to allow for new production levels.
“Long run” is going to affect the AS curve when producers are changing
their production levels permanently.
Full employment is the goal, so the Long Run AS in the vertical range is
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showing where the economy desires to be. (AD should intersect with
LRAS in the lower vertical area)
Guide the students to see that the shifting of the AD curve is affected
by short run or temporary decisions. Changes in spending lead to
more/less production and changes in the PL.
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Point out that the solution for inflation requires a reduction in
employment, which is painful. This is why preventing inflation is
important to economists.
3) The third graph should have AD intersecting AS in the vertical, up
sloping area near the top. A second AD curve should be added to the
left of the first in the middle area of AS. Price levels should decrease
while production stays the same (if still in the vertical range) or
decreases.
2) The AD/AS graph should show the intersection in the left, horizontal
portion of the AS. Add a second AD curve to the right of the first, &
indicate a change in production levels with dotted lines to the
horizontal axis. Price levels will increase or stay the same. Production
(GDP) & employment will increase.
1) Graphs should illustrate a SRAS as upward sloping and a LRAS as the
vertical portion & indicate that it measures full employment output on
the horizontal axis. AD should intersect in the middle area.
3) Have the students draw a third graph that shows an economy with the
problem of inflation. Now, on the same graph, show what would happen if
the government used Fiscal Policy to attempt to improve the inflation
situation. What changes for price levels and production/employment as a
result of this shift?
2) Next, ask them to draw a second graph that illustrates an economy with
the problem of recession. Now, on the same graph, show what would
happen if the government used Fiscal Policy to attempt to improve the
recession situation. What changes for price levels and
production/employment as a result of this shift?
1) Ask them to draw an AD/AS graph and illustrate the difference between
the Short Run AS and the Long Run AS.
Have the students go to the board in pairs or draw on their paper.
Evaluate
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The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the
Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices
Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to
provide the staff development that utilizes content and skills provided in Economics for Educators.
Helping young people learn to think & make better
economic & financial choices in a global economy.
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