Of 241 Chapter 24 From the Short Run to the Long Run: The Adjustment of Factor Prices

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Chapter 24

From the Short Run to the Long Run: The Adjustment of Factor

Prices

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Copyright © 2005 Pearson Education Canada Inc.

Learning Objectives

1. Explain why wages and other factor prices change when there is an output gap.

3. Explain why output gradually returns to potential output following an aggregate demand or supply shock.

2. Explain how induced changes in factor prices affect firms’ costs and shift the AS curve.

4. Recognize how lags and uncertainty place limitations on the use of fiscal policy.

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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!

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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.

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What causes factor price to start changing in the long run adjustment process?

Output Gaps.

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24.1 Output Gaps and Factor Prices

Potential Output and the Output Gap

AS

Y0

•AD

Y*

E0

Output gap

AS

Y1

•AD

Y*

E1

Output gap

Output Gap = Y - Y*

P

Y Y

P

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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.

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When actual GDP is below potential (Y < Y*), the demand for labour (and other factor services) is relatively low.

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.

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.

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Potential Output as an “Anchor”

Following an aggregate demand or supply shock, the short-run 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.

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Potential Output equal to Actual Output

No Output Gap

AS

Y0=

•AD

Y*

E0

Output Gap = Y - Y* = 0

P

Y

Long run equilibrium

AD = AS and output prices are not changing andfactor prices are not changing

Both the output markets and the factor markets are in equilibrium

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Potential Output equal to Actual Output

No Output Gap

AS

Y0=

•AD

Y*

E0

P

Y

Does the economic systemAlways move towards a Long run equilibrium?

How do we get to a long runequilibrium?

All the action is in actor markets.

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24.2 Demand and Supply Shocks

Expansionary AD Shocks AS0

Y1

•

AD0

Y*

E1

AD1

•

E0

P1

P0

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

Inflationary gap opens

Price level rises

But now factor markets are ‘overheated’. There is greater than normal demand for factors and upward pressure on input prices.

Y

P

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Expansionary AD Shocks

AS0

Y1

•

AD0

Y*

E1

AS1

AD1

•

• E2

E0

P2

P1

P0

Step 2: the long run adjustment

As input prices rise, the AS curve shifts back. The output gap begins to close as P increase further and Y falls. This continues until input prices stop increasing and input prices stop increasing when the economy has moved from E1 to E2, returning to Y*

Inflationary gap closes

Price level rises further

This automatic adjustment mechanism eventually eliminates any boom caused by a demand shock by returning Y to Y*. The unusually ‘good times’ self-destruct.

Y

P

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Contractionary AD Shocks

AS0

Y1

•

AD1

Y*

E1 AD0

• E0P0

P1

Recessionary gap opens

Price level falls

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

Y

But now factor markets are ‘slack’. There is less than normal demand for factors and downward pressure on input prices.

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Contractionary AD Shocks

AS0

Y1

•

AD1

Y*

E1

AS1

AD0

•

E2

E0

P2

P0

P1

Recessionary gap closes

Price level falls further

•

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

Y

The automatic adjustment mechanism eventually eliminates the recessionary gap caused by the negative demand shock. IN THEORY!

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Aggregate Supply Shocks

AS0

Y1

•

AD

Y*

E1

AS1

•

E0

P1

P0

Recessionary gap opens

Price level rises

Recessionary gap closes

Price level falls

A negative supply shock causes Y to fall and P to rise.

The adjustment of factor prices then reverses the AS shift and returns the economy to its starting point.

Y

P

Example: Consider an increase in the world price of some important raw materials.

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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.

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.

The US and Canada versus Germany and much of Western Europe- strong labour unions- legislation

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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.

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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.

In other words, full employment of factors will prevail, and output will be at its potential level, Y*.

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.

The vertical line (P,Y) that depicts potential output is sometimes called the long-run aggregate supply curve, or the Classical aggregate supply curve.

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•

AD0

Y0*

E1

AD1

•

E0

P1

P0

In the long run, Y is determined only by potential output — aggregate demand determines P.

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.

P

Y

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•

AD0

Y0*

E1•

E0

P1

P0

Y1*

•

AD0

Y0*

E1

E0P0

P1

•

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

YP

Y

Y1*

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24.3 Fiscal Policy and the Business Cycle

AD0

Y*

AD1

AD0

Y*

•••

•

AS0AS1

AS

Y1 Y1

In the short run, the economy is in equilibrium where the AD curve intersects the AS curve.

Y

PP

YDemand Shock Supply Shock

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In the long run, the economy is in equilibrium at Y = Y*, the position of the vertical Y* curve.

Real GDP

AD

Y*0

Pri

ce

Lev

el

Y*3Y*2Y*1

In the long run, only changes in the level of Y* can change the level of real GDP.

The price level is determined where the AD curve intersects potential output.

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The Basic Theory of Fiscal Stabilization

AD0

Y*

AD1

AD

Y*

••

•

AS0

AS1

AS

Y0 Y0

P0

P1 P0

P1 • E1

E0E1

E0

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.

Y

PP

Y

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AD0

Y*

AD1

AD

Y*

••

•

AS0

AS1

AS

Y0 Y0

P0

P1

P0

P1 •E1

E0

E1

E0

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.

P

Y Y

P

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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.

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.

Automatic vs. Discretionary Fiscal Policy

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.

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• 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

Issues concerning the limitations of discretionary fiscal policy are:

Most economists agree that automatic fiscal stabilizers are desirable and generally work well, but they have concerns about discretionary fiscal policy.

Limitations of Discretionary Fiscal Policy

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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.

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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.

The Paradox of Thrift

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Of 241 Chapter 24 From the Short Run to the Long Run: The Adjustment of Factor Prices