Download Document

1 of 24
Chapter 24
From the Short Run to the
Long Run: The Adjustment
of Factor Prices
2 of 24
Learning Objectives
1. Explain why wages and other factor prices change when
there is an output gap.
2. Explain how induced changes in factor prices affect firms’
costs and shift the AS curve.
3. Explain why output gradually returns to potential output
following an aggregate demand or supply shock.
4. Recognize how lags and uncertainty place limitations on the
use of fiscal policy.
Copyright © 2005 Pearson Education Canada Inc.
3 of 24
The Short Run
The defining characteristics of the short run are:
• factor prices are assumed to be constant, and
• technology and factor supplies are assumed to be
constant.
When the economy has reached a short rum equilibrium, then
The level of output (GDP or Y) and output prices (P) stop
changing.
But what is happening to factor prices? They are assumed to
be fixed in the short run but do they remain fixed for ever?
That depends!
4 of 24
Depending on whether or not the short run equilibrium level of
output is equal to the potential level of output, factor
prices might start to increase, decrease or they might
remain constant.
In the long run factor prices will change to ensure that factor
market remain in equilibrium.
The Adjustment of Factor Prices
During the adjustment process, factor prices are assumed to
be flexible, but technology and factor supplies are constant.
The VERY Long Run
In the long run, factor prices are assumed to have completely
adjusted, and technology and factor supplies are assumed to
be changing.
5 of 24
What causes factor price to start changing in the long run
adjustment process?
Output Gaps.
6 of 24
24.1 Output Gaps and Factor Prices
Potential Output and the Output Gap
AS
P
AS
P
E0
E1
•
•
AD
Output
gap
Y*
Y0
AD
Output
gap
Y
Y1
Y*
Y
Output Gap = Y - Y*
Copyright © 2005 Pearson Education Canada Inc.
7 of 24
Factor Prices and the Output Gap
An Inflationary Output Gap
When actual GDP exceeds potential GDP (Y>Y*), the demand
for labour (and other factor services) is relatively high.
The boom that is associated with an inflationary gap
generates a set of conditions — high profits for firms and
unusually large demand for labour — that causes wages and
unit costs to rise.
This might be true for many inputs, not just labour.
It might not be true for labour but true for other key inputs.
8 of 24
When actual GDP is below potential (Y < Y*), the demand for
labour (and other factor services) is relatively low.
The slump that is associated with a recessionary gap
generates a set of conditions — low profits for firms and low
demand for labour — that causes wages and unit costs to
fall.
Again this is likely true for other (all?) inputs.
Speed of Factor-Price Adjustment
The speed of factor-price adjustment depends on the situation
— booms typically cause wages to rise rapidly, whereas
slumps often cause wages to fall only slowly.
9 of 24
Potential Output as an “Anchor”
Following an aggregate demand or supply shock, the shortrun equilibrium level of output may be different from potential
output. As a result, wages and other factor prices will adjust,
eventually bringing the equilibrium level of output back to
potential.
When Y = Y*, the unemployment rate equals the NAIRU, the
natural rate of unemployment (denoted U*).
U* includes both structural and frictional unemployment.
Copyright © 2005 Pearson Education Canada Inc.
10 of 24
Potential Output equal to Actual Output
No Output Gap
AS
P
Long run equilibrium
E0
•
AD
Y0= Y*
Output Gap = Y - Y* = 0
Y
AD = AS and output prices
are not changing and
factor prices are not changing
Both the output markets
and the factor markets
are in equilibrium
11 of 24
Potential Output equal to Actual Output
No Output Gap
AS
P
Does the economic system
Always move towards a
Long run equilibrium?
E0
•
AD
Y0= Y*
Y
How do we get to a long run
equilibrium?
All the action is in
actor markets.
12 of 24
24.2 Demand and Supply Shocks
Expansionary AD Shocks
AS0
P
Step 1: the short run
adjustment
A positive demand shock
first raises P and Y, causing
an inflationary gap to open
as the economy moves
from E0 to E1
P1
P0
• E1
Price level
rises
• E0
AD1
Inflationary gap
opens
Y*
AD0
Y1
Y
But now factor markets are ‘overheated’. There is greater
than normal demand for factors and upward pressure on input
prices.
13 of 24
Expansionary AD Shocks
Step 2: the long run
adjustment
AS1
P
As input prices rise, the AS
curve shifts back. The output P2
gap begins to close as P
P1
increase further and Y falls.
This continues until input
P0
prices stop increasing and
input prices stop increasing
when the economy has moved
from E1 to E2, returning to Y*
Price level
rises further
AS0
• E2
• E1
• E0
AD1
Inflationary
gap closes
AD0
Y*
Y1
Y
This automatic adjustment mechanism eventually eliminates
any boom caused by a demand shock by returning Y to Y*.
The unusually ‘good times’ self-destruct.
14 of 24
Contractionary AD Shocks
Step 1: the short run
adjustment
A negative demand shock
first reduces P and Y,
causing a recessionary
output gap to open as the
economy moves from E0 to
E1
P
P0
AS0
Price level
falls
• E0
• E1
P1
AD0
Recessionary
gap opens
AD1
Y1
Y*
But now factor markets are ‘slack’. There is less than
normal demand for factors and downward pressure on
input prices.
Y
15 of 24
Contractionary AD Shocks
Step 2: the long run
adjustment
As input prices fall, the AS
curve shifts out. The output
gap begins to close as P
falls further and Y
increases. This continues
until input prices stop falling
when the economy has
moved from E1 to E0,
returning to Y*
P
P0
AS0
Price level
falls further
• E0
• E1
P1
P2
AS1
• E2
Recessionary
gap closes
AD0
AD1
Y1
Y*
The automatic adjustment mechanism eventually
eliminates the recessionary gap caused by the negative
demand shock. IN THEORY!
Y
16 of 24
Aggregate Supply Shocks
Price level
P rises
Price level
falls
P1
A negative supply shock
causes Y to fall and P to rise.
AS1
AS0
E1
The adjustment of factor
prices then reverses the AS
shift and returns the
economy to its starting
point.
•
• E0
P0
Recessionary
gap opens
Recessionary Y1
gap closes
AD
Y*
Y
Example: Consider an increase in the world price of
some important raw materials.
17 of 24
It Matters how Quickly Wages Adjust!
Following either a demand or supply shock, the speed at
which the economy returns to Y* depends on the amount of
wage flexibility.
Wages that are flexible — and thus change rapidly during
output gaps — provide an automatic adjustment mechanism
that pushes the economy back toward potential output.
But if wages are sticky or rigid, the economy’s adjustment
mechanism is sluggish and thus output gaps tend to persist.
The US and Canada
versus Germany and much of Western Europe
- strong labour unions
- legislation
18 of 24
Economic Shocks and Business Cycles
Both aggregate demand and aggregate supply are subject to
continual random shocks.
The economy’s automatic adjustment mechanism converts
these shocks into cyclical fluctuations in real GDP.
Because of the significant lags in the economy’s responses to
these shocks, changes in output are drawn out over
substantial periods of time.
Copyright © 2005 Pearson Education Canada Inc.
19 of 24
Long-Run Equilibrium
The economy is in a state of long-run equilibrium when factor
prices are no longer adjusting to output gaps.
In other words, full employment of factors will prevail, and
output will be at its potential level, Y*.
The vertical line (P,Y) that depicts potential output is
sometimes called the long-run aggregate supply curve, or the
Classical aggregate supply curve.
This curve is vertical because there is no relationship in the
long run between the price level and the amount of output
that the economy can produce under full employment.
Copyright © 2005 Pearson Education Canada Inc.
20 of 24
P
In the long run, Y is
determined only by potential
output — aggregate demand
determines P.
P1
•E1
P0
•E0
AD1
AD0
Y0*
Whatever short run shocks occur, once the long run
adjustment is complete the economy ends up back at Y*.
This is the potential level of output given the current
technology and supply of factors.
Y
21 of 24
However, if technology were
to improve and/or factor
supplies were to increase,
than the economies potential
output would increase. The
result would be more output
and lower prices. This is
long run economic growth.
Could an economy ever
suffer long run economic
decline? Certainly, war
revolution, AIDS, etc. There
are many possible causes of
technological decline and/or
decreased factor supplies
P
P0
•E0
•
P1
E1
AD0
Y0*
Y1*
Y
P
P1
•
E1
•
P0
E0
AD0
Y1*
Y0*
Y
22 of 24
24.3 Fiscal Policy and the Business Cycle
P
P
AS
AS0
AS1
•
AD1
•
•
AD0
Y*
Y1
Demand Shock
•
AD0
Y
Y*
Y1
Y
Supply Shock
In the short run, the economy is in equilibrium where the AD
curve intersects the AS curve.
Copyright © 2005 Pearson Education Canada Inc.
23 of 24
In the long run, the economy is in equilibrium at Y = Y*, the
position of the vertical Y* curve.
Price Level
The price level is determined
where the AD curve intersects
potential output.
AD
Y*0 Y*1 Y*2
Real GDP
In the long run, only changes
in the level of Y* can change
the level of real GDP.
Y*3
Copyright © 2005 Pearson Education Canada Inc.
24 of 24
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
(increase in G or decrease in T) or by a (possibly slow)
rightward shift in the AS curve.
25 of 24
P
P
AS1
AS0
AS
E1
P0
P1
P1
P0
• E0
E1
AD0
•
Y*
•
• E0
AD
AD1
Y0
Y
Y*
Y0
Y
An inflationary gap may be removed by a leftward shift in AD
(a decrease in G or an increase in T) or by a leftward shift of
AS.
When the economy’s adjustment mechanism is slow to
operate, there is a potential stabilizing role for fiscal policy.
26 of 24
Automatic vs. Discretionary Fiscal Policy
Discretionary fiscal policy occurs when the government
decides to change G and/or T in an effort to change real GDP.
Discretionary fiscal policy is reflected in a shift of the AD
curve.
The upward slope of the budget surplus function means
that there are fiscal effects that cause the tax-and-transfer
system to act as an automatic stabilizer for the economy.
As real GDP rises, tax revenues rise, and this reduces
expenditure, dampening the increase in GDP. As real GDP
falls, tax revenues fall, and this increases expenditure,
dampening the fall of real GDP.
Copyright © 2005 Pearson Education Canada Inc.
27 of 24
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.
Issues concerning the limitations of discretionary fiscal policy
are:
• long and uncertain lags - Do we really know how fast
these adjustments occur?
• temporary versus permanent changes in policy, and
• the impossibility of “fine tuning” - How precisely can we
determine the effects of the changes in G or T
Copyright © 2005 Pearson Education Canada Inc.
28 of 24
Fiscal Policy and Growth
The desirability of using fiscal policy to stabilize the economy
depends a great deal on the speed with which the economy’s
automatic adjustment mechanism returns the economy to
potential output.
Fiscal stabilization policy will generally have consequences for
economic growth:
• an increase in G temporarily increases real GDP,
• investment is lower in the new long-run equilibrium, and
• this may reduce the rate of growth of potential output.
29 of 24
The Paradox of Thrift
The paradox of thrift (the idea that an increase in saving
reduces the level of real GDP) is only true in the short run,
when the level of aggregate demand is relevant for
determining real GDP.
In the long run, an increase in desired saving has the
following effects:
• the price level falls,
• investment rises, and
• output returns to its potential level.
Copyright © 2005 Pearson Education Canada Inc.
30 of 24