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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
2 of 24
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
6/e.
O’Sullivan, Sheffrin, Perez
Macroeconomics: Principles, Applications, and Tools
Modern Macroeconomics:
From the Short Run to the
Long Run
They could not have differed
more sharply on economic
theory and policy.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
APPLYING THE CONCEPTS
1
What went wrong for the Japanese economy during its
decade-long economic downturn?
Japan’s Lost Decade
2
What are the links between presidential elections and
macroeconomic performance?
Elections, Political Parties, and Voter Expectations
3
Will increases in health-care expenditures crowd out
consumption or investment spending?
Increasing Health-Care Expenditures and Crowding Out
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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15.1
LINKING THE SHORT RUN AND THE
LONG RUN
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
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
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
Wages and Prices and Their Adjustment over Time
● wage–price spiral
The process by which changes in wages
and prices cause further changes in
wages and prices.
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15.2
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO
FULL EMPLOYMENT
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
Returning to Full Employment from a Recession
 FIGURE 15.1
How the Economy Recovers from a Downturn
If the economy is operating below full employment, as shown in Panel A, prices will fall, shifting
down the short-run aggregate supply curve, as shown in Panel B.
This will return output to its full-employment level.
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO
FULL EMPLOYMENT
Returning to Full Employment from a Boom
 FIGURE 15.2
How the Economy Returns 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.
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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15.2
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO
FULL EMPLOYMENT
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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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO
FULL EMPLOYMENT
Economic Policy and the Speed of Adjustment
FIGURE 15.3
Using Economic Policy to
Fight a Recession
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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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
APPLICATION
1
JAPAN’S LOST DECADE
APPLYING THE CONCEPTS #1: What went wrong
for the Japanese economy during its decade-long
economic downturn?
Following World War II, Japan’s economy grew rapidly. However, around 1992 it ground
to a halt, and by 1993–1994 the country was suffering from a recession. Prices stopped
rising, and deflation—falling prices—began in Japan.
Deflation might sound like a good thing, but it actually caused a lot of problems for
Japan.
• Wholesale prices fell for several years.
• Also, starting in 1990, real-estate prices fell nearly 50 percent.
• Banks lost vast sums of money on real-estate-related loans.
• For Japanese borrowers, falling prices—a negative inflation rate—raised the real
rate of interest they were paying on their existing loans, essentially increasing
their burden of debt.
• Result: aggregate demand was weak.
Restoring the health of the banking system was a major priority. Toward the beginning of
the next decade of 2000, the economy began to improve somewhat. Beginning in 2003,
the Japanese economy grew by 2.3 percent, up from nearly no growth at all.
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15.2
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO
FULL EMPLOYMENT
Liquidity Traps
● 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
reelection prospects.
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
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 favor to gain reelection. 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.
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15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
15 of 24
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
 FIGURE 15.4
How the Changing Price Level Restores the Economy to Full Employment
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
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
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
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
The Long-Run Neutrality of Money
 FIGURE 15.5
Monetary Policy in the Short
Run and the Long Run
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
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
The Long-Run Neutrality of Money
 FIGURE 15.6
The 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
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
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
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
Crowding Out in the Long Run
 FIGURE 15.7
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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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
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 the mid-century.
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
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
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
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to
the Long Run
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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