Download From the Short Run to the Long Run

Economics
NINTH EDITION
Chapter 15
Insert Cover Picture
Modern
Macroeconomics:
From the Short Run
to the Long Run
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Learning Objectives
15.1 Describe the key difference between the short run and
long run in macroeconomics.
15.2 Demonstrate graphically how the economy can return to
full employment.
15.3 Analyze monetary neutrality and crowding out using
graphs.
15.4 Assess how classical economic doctrines relate to
modern macroeconomics
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15.1 LINKING THE SHORT RUN AND
THE LONG RUN (1 of 2)
The Difference between the Short and Long Run
●
Short run in macroeconomics
The period of time in which prices do not change or do not change very much.
●
Long run in macroeconomics
The period of time in which prices have fully adjusted to any economic changes.
Should economic policy be guided by what we expect to happen in the short run, as
Keynes thought, or what we expect to happen in the long run, as Friedman thought? To
answer this question, we need to know two things:
1 How does what happens in the short run determine what happens in the long run?
2 How long is the short run?
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15.1 LINKING THE SHORT RUN AND
THE LONG RUN (2 of 2)
Wages and Prices and Their Adjustment over Time
REAL - NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not its “face” value.
●
Wage–price spiral
The process by which changes in wages and prices
cause further changes in wages and prices.
TABLE 15.1 Unemployment, Output, and Wage and Price Changes
When unemployment is below the natural
rate …
When unemployment is above the natural
rate …
•
•
•
•
output is above potential.
wages and prices rise.
output is below potential
wages and prices fall.
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APPLICATION 1
SECULAR STAGNATION?
APPLYING THE CONCEPTS #1: Why have some economists revived the idea of “secular
stagnation”?
• In the 1930s Alvin Hansen, argued the economy suffered fro secular stagnation. According to this
theory, there was not enough aggregate demand to bring the economy t full employment and the
natural adjustment process would not work as interest rate could not fall enough.
• The only remedy was government spending. World War II brought enough demand and the concept
disappeared. Lawrence Summers, former U.S. Secretary of the Treasury resurrected the theory. He
believes that a series of structural factors have decreased the demand for investment goods and
interest rates cannot fall far enough to create sufficient aggregate demand. He believes infrastructure
spending makes sense at this time and will increase aggregate demand
• He believes that easy credit fuelled a stock market boom n the late 1990s and later the housing boom
in the 2000s and that is the only reason we have had sufficient demand in the last few decades.
• Critics say the economy has grown consistently since the last recession and the unemployment rate
in 2015 was at or near full employment. Although infrastructure spending is a good idea, it is not
necessary to achieve full employment.
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15.2 HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (1 of 6)
Using aggregate demand and aggregate supply, we can illustrate graphically how changing
prices and wages help move the economy from the short to the long run.
1 Aggregate demand.
• Aggregate demand curve
A curve that shows the relationship between the level of prices and the quantity of real GDP
demanded.
2 Aggregate supply.
• Short-run aggregate supply curve
A relatively flat aggregate supply curve that represents the idea that prices do not change very
much in the short run and that firms adjust production to meet demand.
• Long-run aggregate supply curve
A vertical aggregate supply curve that reflects the idea that in the long run, output is determined
solely by the factors of production and technology.
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15.2 HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (2 of 6)
Returning to Full
Employment from a
Recession
If the economy is operating below full
employment, as shown in Panel A,
prices will fall, shifting down the shortrun aggregate supply curve, as shown
in Panel B.
This will return output to its fullemployment level.
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15.2 HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (3 of 6)
Returning to Full
Employment from a Boom
If the economy is operating above full
employment, as shown in Panel A,
prices will rise, shifting the short-run
aggregate supply curve upward, as
shown in Panel B.
This will return output to its
full-employment level.
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15.2 HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (4 of 6)
Returning to Full Employment from a Boom
In summary:
• If output is less than full employment, prices will fall as the economy returns to full
employment.
• If output exceeds full employment, prices will rise and output will fall back to full
employment.
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15.2 HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (5 of 6)
Economic Policy and the Speed
of Adjustment
Rather than letting the economy naturally
return to full employment at point b,
economic policies could be implemented to
increase aggregate demand from AD0 to AD1
to bring the economy to full employment at
point c.
The price level within the economy, however,
would be higher.
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15.2 HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (6 of 6)
Liquidity Traps or Zero Lower Bound
● Liquidity trap
A situation in which nominal interest rates are so low, they can no longer fall.
Political Business Cycles
● Political business cycle
The effects on the economy of using monetary or fiscal policy to stimulate the economy before
an election to improve re election prospects.
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APPLICATION 2
ELECTIONS, POLITICAL PARTIES, AND VOTER EXPECTATIONS
APPLYING THE CONCEPTS #2: What are the links between presidential elections and
macroeconomic performance?
The original political business cycle theories focused on incumbent presidents trying to manipulate the
economy in their favour to gain re election. Subsequent research began to incorporate other, more
realistic factors.
• The first innovation was to recognize that political parties could have different goals or
preferences.
• Republicans historically have been more concerned about fighting inflation, whereas
Democrats have placed more weight on reducing unemployment.
• The second major innovation was to recognize that the public would anticipate that politicians will
try to manipulate the economy.
• If the public is not sure who will win the election, the outcome will be a surprise to them—a
contractionary surprise if Republicans win and an expansionary surprise if Democrats win.
• This suggests that economic growth should be less if Republicans win and greater if
Democrats win. The postwar U.S. evidence is generally supportive of this theory
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15.3 THE ECONOMICS BEHIND THE
ADJUSTMENT PROCESS (1 of 7)
REAL - NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not its “face” value.
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15.3 THE ECONOMICS BEHIND THE
ADJUSTMENT PROCESS (2 of 7)
With the economy initially below
full employment, the price level
falls, as shown in Panel A,
stimulating output.
In Panel B, the lower price level
decreases the demand for money
and leads to lower interest rates
at point d.
In Panel C, lower interest rates
lead to higher investment
spending at point f.
As the economy moves down the
aggregate demand curve from
point a toward full employment at
point b in Panel A, investment
spending increases along the
aggregate demand curve.
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15.3 THE ECONOMICS BEHIND THE
ADJUSTMENT PROCESS (3 of 7)
Why changes in wages and prices restore the economy to full employment:
(1) Changes in wages and prices change the demand for money.
(2) This changes interest rates, which then affect aggregate demand for goods and
services and ultimately GDP.
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15.3 THE ECONOMICS BEHIND THE
ADJUSTMENT PROCESS (4 of 7)
The Long-Run Neutrality of
Money
As the Fed increases the supply of
money, the aggregate demand curve
shifts from AD0 to AD1 and the
economy moves to point a.
In the long run, the economy moves to
point b.
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15.3 THE ECONOMICS BEHINE THE
ADJUSTMENT PROCESS (5 of 7)
The Long-Run Neutrality of
Money
Starting at full employment, an
increase in the supply of money from
Ms0 to Ms1 will initially reduce interest
rates from rF to r0 (from point a to point
b) and raise investment spending from
IF to I0 (point c to point d). We show
these changes with the red arrows.
The blue arrows show that as the price
level increases, the demand for money
increases, restoring interest rates and
investment to their prior levels—rF and
IF, respectively. Both money supplied
and money demanded will remain at a
higher level, though, at point e.
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15.3 THE ECONOMICS BEHIND THE
ADJUSTMENT PROCESS (6 of 7)
The Long-Run Neutrality of Money
●
Long-run neutrality of money
A change in the supply of money has no effect on real interest rates, investment, or output in
the long run.
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15.3 THE ECONOMICS BEHIND THE
ADJUSTMENT PROCESS (7 of 7)
Crowding Out in the Long
Run
Starting at full employment, an increase
in government spending raises output
above full employment. As wages and
prices increase, the demand for money
increases, as shown in Panel A, raising
interest rates from r0 to r1 (point a to
point b) and reducing investment from I0
to I1 (point c to point d ).
The economy returns to full
employment, but at a higher level of
interest rates and a lower level of
investment spending.
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APPLICATION 3
INCREASING HEALTH-CARE EXPENDITURES AND CROWDING OUT
APPLYING THE CONCEPTS #3: Will increases in health-care expenditures crowd out
consumption or investment spending?
• In 1950, health-care expenditures in the United States were 5.2 percent of GDP; by 2000, this share
had risen to 15.4 percent.
• Since 1950, the average life span has increased by 1.7 years per decade.
• Two economists, Charles I. Jones and Robert E. Hall, go further and suggest normal increases in
economic growth will propel health-care expenditures to approximately 30 percent of GDP by midcentury.
• Their argument is that as societies grow wealthier, individuals face the tradeoff of buying more goods
(automobiles or cars) to enjoy their current life span or spending more on health care to extend their
lives.
• Assuming this argument is correct and health-care expenditures increase, what other component of
GDP will fall?
• If investment is crowded out, living standards would fall in the long run, reducing the ability to
consume both health and non-health goods.
• Spending on health would then come at the expense of spending on consumer durables or larger
houses. That would be the preferred outcome.
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15.4 CLASSICAL ECONOMICS IN
HISTORICAL PERSPECTIVE
Say’s Law
Classical economics is often associated with Say’s law, the doctrine that “supply
creates its own demand.”
Keynes argued that there could be situations in which total demand fell short of total
production in the economy for extended periods of time.
Keynesian and Classical Debates
If wages and prices are not fully flexible, then Keynes’s view that demand could fall
short of production is more likely to hold true.
However, over longer periods of time, wages and prices do adjust and the insights of
the classical model are restored.
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KEY TERMS
Aggregate demand curve
Liquidity trap
Long-run aggregate supply curve
Long run in macroeconomics
Long-run neutrality of money
Political business cycle
Short-run aggregate supply curve
Short run in macroeconomics
Wage–price spiral
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