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Chapter 24
From the Short Run to the
Long Run: The Adjustment of
Factor Prices
Copyright © 2011 Pearson Canada Inc.
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In this chapter you will learn...
1. …why output gaps cause wages and other factor prices
to change.
2. …how induced changes in factor prices affect firms’ costs
and shift the AS curve.
3. …why real GDP gradually returns to potential output
following an AD or AS shock.
4. …why lags and uncertainty place limitations on the use of
fiscal stabilization policy.
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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
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24.1 The Adjustment Process
Potential Output and the Output Gap
AS
P
AS
P
E0
E1
•
Output
gap
Y*
Y0
•
AD
AD
Output
gap
Y
Y1
Y*
Y
Output Gap = Y - Y*
NOTE: The adjustment to E0 or E1 occurs fairly quickly
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Factor Prices and the Output Gap
In the long run wages and profits generally increase at the
rate of productivity growth.
During some historical periods (long periods) workers might
make gains relative to capitalist (wages go up faster than
profits)
During other historical periods (long periods) capitalist might
make gains relative to workers (profits go up faster than
wages)
But what is being divided are the gains from productivity
growth
We saw that average annual productivity growth is about 1.5%
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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
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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*
Actually, during a recession wages rise more slowly than productivity increases,
so unit costs fall.
During an inflationary period wages rise more quickly than does productivity,
so unit costs rise.
* assuming no inflation and productivity growth
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Adjustment asymmetry:
- inflationary output gaps typically raise wages rapidly
- recessionary output gaps often reduce wages only
slowly
(recall that what is really happening is that wages are
constant, or increasing very slowly, and productivity must
increase faster in order for unit costs to fall – this takes time)
This general adjustment process — from output gaps to
factor prices — is summarized by the Phillips Curve.
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The Phillips curve was originally drawn as a negative
relationship between the unemployment rate and the rate of
change in nominal wages.
Y > Y* => excess demand for labour => wages rise
Y < Y* => excess supply for labour
=> wages fall
Y = Y* => no excess supply/demand => wages constant
EXTENSIONS IN THEORY 24-1
The Phillips Curve and the Adjustment Process
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Really, what we are interested in is: How fast are wages rising relative to
productivity growth? If productivity (output per person hour) grows at 2%
then wages can grow at 2% without any effect on cost per unit (the AS
curve will not shift).
Y > Y* => excess demand for labour => wages tend to
rise faster than productivity (AS shifts up and back)
Y < Y* => excess supply for labour
=> wages tend to
rise more slowly than productivity (AS shift down and out)
Y = Y* => no excess supply/demand => wages rise and
the same rate as productivity (AS does not shift)
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*
Offsetting changes in wages
and productivity
An increase in wages
causes a negative supply
shock
An increase in productivity
causes a positive supply
shock
If wage rise at the same rate as
productivity increases then there
is no net effect
AS’0
P
Net negative supply shock if wages
rise faster than productivity
Net positive supply shock if wages
rise more slowly than productivity
AS0
AS’’0
P0
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•
AD
Y0
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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
Y* - LONG RUN EQUILIBRIUM LEVEL OF OUTPUT
When Y = Y*, the unemployment rate equals NAIRU, U*.
- there is both structural and frictional unemployment
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24.2 Aggregate Demand and
Supply Shocks
Expansionary AD Shocks
AS1
P
The economy’s
adjustment process
eventually eliminates
any boom caused by a
demand shock,
returning Y to Y*.
P2
P1
P0
Price level
rises further
Price level
rises
AS0
• E2
• E1
• E0
Inflationary gap
opens
Inflationary Y*
gap closes
AD1
AD0
Y1
Y
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Contractionary AD Shocks
The economy’s
adjustment process
works following
negative demand
shocks, too.
- although it may be
slower because of
“sticky wages”
P
P0
P1
AS0
AS1
Price level
falls further
• E0
• E1
P2 Recessionary
gap closes
opens
Y1
• E2
AD0
AD1
Y*
Y
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Aggregate Supply Shocks
P
P1
AS1
Price level
rises
falls
AS0
E1
•
After a negative
supply shock, the
adjustment of factor
prices reverses the
AS shift and returns
real GDP to Y*.
• E0
P0
Recessionary
gap closes
opens
Y1
AD
Y*
Y
Example: Consider an
increase in the world
price of some important
raw materials.
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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
(longer recessions result).
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EXTENSIONS IN THEORY 24-2
The Business Cycle:
Additional Pressures for Adjustment
Role of expectations/replacement I and the dynamics of the
business cycle.
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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.
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P
In the long run, Y is
determined only by potential
output — aggregate demand
determines P.
P1
•E1
P0
•E0
AD1
AD0
Y
Y0*
P
For a given AD curve,
long-run growth in Y*
results in a lower price
level.
P0
•E0
•
P1
E2
AD0
Y0*
Y1*
Y
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24.3 Fiscal Stabilization Policy
The motivation for fiscal stabilization policy is to reduce the
volatility of aggregate outcomes.
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.
www.myeconlab.com
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The Basic Theory of Fiscal Stabilization
P
P
AS0
AS
AS1
• E1
P1
P0
•
P0
P1
AD1
E0
E0
•
• E1
AD0
Y0 Y*
AD
Y
Y0
Y*
Y
A recessionary gap may be closed by a rightward shift in AD
or by a (possibly slow) rightward shift in the AS curve.
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P
P
AS1
AS0
AS
E1
• E0
P0
P1
P1
P0
E1
AD0
•
Y*
•
• E0
AD
AD1
Y0
Y
Y*
Y0
Y
An inflationary gap may be removed by a leftward shift in AD,
or by a leftward shift of AS.
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The Paradox of Thrift
Occurred recently in the US economy
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*
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Paradox of Thrift
Household want to save more – desired Savings increase
P
AS0
But the resulting negative
demand shock causes Y
Price level
to fall to Y1 in the short run
falls further
P0
• E0
-savings actually decrease
P1
• E1
in the short run
• E2
P2 Recessionary
After factor prices and P
adjust AS shifts out
and Y returns to Y*
gap closes
opens
Y1
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Y*
AS1
AD0
AD1
Y
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Increases in the desired Savings of households
In the long run the increase in S (decrease in C) will
result in an increase in I and a shift out in Y*
P
AS0 AS1
Much of this happens through Price level
changes in r which we will
falls
P0
study later
P1
AS1
• E0
E2
•
• E1
The higher short run Savings
Recessionary
lead to greater Investment
gap opens
and growth in long run
Y1
supply - increase in Y* to Y**
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AD0
AD1
Y* Y**
Y
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LESSONS FROM HISTORY 24-1
Fiscal Policy in the Great Depression
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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
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Practical Limitations of 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”
• regionalized nature of Canada
• Federal/Provincial powers
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APPLYING ECONOMIC CONCEPTS 24-1
Canada’s Fiscal Response
to the 2008-2009 Recession
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Fiscal Policy and Growth
Fiscal stabilization policy will generally have consequences for
economic growth.
For example:
• an increase in G temporarily increases real GDP
• investment is lower in the new long-run equilibrium
• this may reduce the rate of growth of potential output
Crowding Out
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