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Flashcards in Short run to long run Deck (21):

3 macroeconomic states

Define Potential Output

1) Short run
2) Adjustment of Factor Prices (takes economy from SR to LR)
3) Long run

Potential Output (Y*): total output that can be produced when all productive resources (land, labour, capital) are fully employed (not maximized)


Short Run Assumptions


1) Factor prices (inputs) are assumed to be exogenous (CONSTANT)

2) Technology and factor supplies are CONSTANT (therefore Y* is constant)

Real GDP (Y) is determined by AD and AS
- show effects of AD and AS shocks on real GDP


Adjustment of Factor Prices Assumptions


1) Factor prices (inputs) are assumed to ADJUST/FLEXIBLE in response to output gaps (endogenous)
- ex: inflationary output gap means higher wages

2) Technology and factor supplies are assume to be CONSTANT (Y* is constant)
- same as SR assumption (in reality, both are changing all the time)

Factor prices adjust to output gaps and causes real GDP to eventually return back to Y*


Long Run Assumptions

1) factor prices are assumed to HAVE fully adjusted to any output gap

2) technology and factor supplies are assumed to be CHANGING (Y* is changing)

- long-run growth


What are the types of output gaps (IN THE SHORT RUN)

What is happening in each (factor prices, unit costs)?

Recall Output gap is when actual GDP differs from potential GDP (Y*)
Output gap = Y - Y*

Inflationary Output Gap: Y > Y*
(Y0 is to the right of Y*)
- firms are producing beyond their normal capacity output
- excess demand for all factor inputs (including labour)
- firms will try to bid workers away from other firms in order to maintain high levels of output and sales made possible by boom conditions
- higher wages
- unit costs also rise

Recessionary Output Gap: Y < Y*
(Y0 is to the left of Y*)
- firms are producing below their normal capacity output
- excess supply of all factor inputs (including labour)
- lower wages
- unit costs also fall


Downward Wage Stickiness
(adjustment asymmetry)

Upward and downward adjustments to wages and unit costs occur at DIFFERENT SPEEDS

During booms, wages RISE RAPIDLY

During recessions, wages FALL SLOWLY (sticky wages)
- therefore, AS curve shifts to the RIGHT (downward) slowly


Phillips Curve

observed that wages tend to FALL in periods of HIGH unemployment and RISE in periods of LOW unemployment

- negative relationship between unemployment and rate of change in wages


Potential output as an "anchor"

Following an AD or AS shock, the SR equilibrium level of output changes from Y*

This output gap causes factor prices to adjust, eventually bringing the equilibrium level of output back to Y*


Positive AD Shocks

Natural Adjustment Process

Increase in AD, shift AD right
- maybe because of increase in autonomous expenditure (increase in business confidence = increase in I)

Creates inflationary gap

Natural Process:
- wages and factor prices increase, causing input prices to increase
- AS shifts left

- same real GDP
- higher price level


Negative AD Shocks

Natural Adjustment Process

Decrease in AD, shift AD left
- maybe because of decrease in autonomous expenditure (reduction in investment, reduction in exports etc.)

Creates recessionary gap

Natural Process:
- wages and factor prices decrease, causing input prices to decrease
- AS curve shifts slowly to the right

- same real GDP
- lower price level

*wages maybe flexible or sticky
- if sticky wages, may take a long time before recessionary gap is closed (sluggish adjustment process)

Therefore we need fiscal policy to speed things up!


AS shocks


Natural Adjustment Process

Positive AS shock, such as...
- increase in price of oil (input price), shift AS left

Negative AS Shocks also occur

Stagflation = fall in real GDP and high price level

Whenever AS shock occurs, the natural process simply REVERSES the AS shift

- same real GDP
- same price level


Long Run Equilibrium

Changes in LR Equilibrium

LR equilibrium is when the adjustment process is complete and there is no output gap

Vertical Y* = LRAS curve


AD and AS intersect at Y*

Changes in LR Equilibrium:
- when AD shifts, the price level changes. However, real GDP remains unchanged in the long run
- only when potential output (Y*) changes will both price and real GDP change
(occurs when vertical Y* shifts left or right)


Fiscal Stabilization Policy

Alternatives to fiscal stabilization policy

Involves changing G or t (tax rates)

When G changes, this shifts both AE and AD (PARALLEL)

When t changes, this changes the SLOPE of both AE and AD

1) Expansionary fiscal policy: increasing G or decreasing t

2) Contractionary Fiscal policy: decreasing G or increasing t

- disadvantage: economy may overshoot its potential output

1) natural economy's adjustment process (shift in AS curve)

2) wait for the recovery of private-sector demand (shift in AD curve)


Paradox of Thrift
in SR and LR?

An increase in savings REDUCES the level of real GDP (in short run)
- if many people saved at the same time, the country's total desired saving would increase, causing Consumption to decrease
- results in AD shift left
- this reduces equilibrium real GDP in SR

Called Paradox of Thrift because what is good for any individual when viewed in isolation ends up being undesirable for the economy as a whole

The Paradox of Thrift does not apply AFTER factor prices have fully adjusted and economy is at LR equilibrium
- In the long run, the path of real GDP is determined by the path of Y*, not changes in AD!

An increase in saving has the long-run effect of increasing investment and raising Y*


Automatic Fiscal Stabilizers

- if AD shifts right, SR Y increases
- as Y increases, government tax revenues increase (T = tY)
- rise in T dampens the overall increase in real GDP caused by the initial shock
- multiplier is reduced and therefore, the tax-and-transfer system acts as an automatic stabilizer

(same thing for if AD shifts left, government tax revenues decrease)

A stabilizer is anything that causes small change in Y (small simple multiplier)

Also steeper AS curve causes less changes in real Y


Limitations of discretionary Fiscal Policy

1) decision and execution lags (takes too long)

2) Temporary versus Permanent Tax Changes
- the more closely household consumption expenditure is related to lifetime income rather than to current income, the smaller will be the effects on current consumption

(the more FORWARD-looking households are, the SMALLER will be the effects of what are perceived to b temporary changes in taxes)

3) Fine Tuning vs. Gross Tuning
- fine tuning: use of fiscal and monetary policy to offset virtually all fluctuations in private-sector spending to keep real GDP near Y*

- Gross tuning: use of fiscal and monetary policy to remove LARGE and PERSISTENT output gaps


Fiscal Policy and Growth (IMPORTANT FOR LR THEORY Q)

increase in G when Y* is unchanged and changed?

Reduction in taxes?

1) Increase in G leaves Y* unchanged
- increase in G has crowded out private expenditures

If Y = Ca + Ia + Ga + NXa and Ga increases but Y remains unchanged

Therefore, Ca, Ia, and NXa must have DECREASED

2) Increase in G causes Y* to rise
- increase in G on public INFRASTRUCTURE increases PRODUCTIVITY of private sector production = Y* has increased
- therefore, the negative effects from crowding out of private investment will be reduced

Reductions in Taxes:
- reduction in corporate or personal income-tax rate will INCREASE investment and consumption = shift AD right
- reduction in taxes may also INCREASE Supply of labour = shift AS right

LR: reductions in personal and corporate income-tax rates may increase future growth rate of Y*
- increasing labour force (personal income tax)


Permanent increases in real GDP are only possible if ____ is increasing

potential output, Y*


Is a reduction in personal and corporate income tax a supply side or demand side policy?


Personal income tax:
Demand Side -
- increases disposable income
- increases CONSUMPTION, shift AD right

Supply side -
- increase the return to working
- increase supply of labour
- shift AS curve to the right (due to downward pressure on wages?)
- may lead to LR increases in Y* due to growth in labour force

Corporate income tax:
Demand side
- increase INVESTMENT demand, shift AD right

Supply side -
- reduce firms' costs, shift AS right


Decreasing taxes?

Tax Rebate?

Decreasing taxes changes the slope of AE and AD curve

A tax rebate increases Yd and consumption (i.e. 5b lump sum). This is similar to an autonomous increase in consumption, shifting AE curve up and AD curve to the right


Importance of factor utilization rates in SR and LR?

What about changes in factor supply (supply of labour)?

- factor utilization rate fluctuates in response to SR changes in output caused by aggregate demand or aggregate supply shocks. Therefore, Changes in the factor utilization rate are important for explaining SR changes in GDP.
- Over time, however, excess supply or excess demand for factors cause an adjustment in factor prices that brings the factor utilization rate back to its "normal" level (Y*). Therefore, changes in the factor utilization rate are not important for explaining LRchanges in GDP

- Changes in the economy's supply of labour and capital occur gradually, but over periods of many years their growth is considerable.
- As a result, changes in factor supply are important for explaining LR changes in output but relatively unimportant for explaining SR changes