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Chapter 24. From the Short Run to the Long Run: The Adjustment of Factor…
Chapter 24. From the Short Run to the Long Run: The Adjustment of Factor Prices
The output gap and factor prices
output gap: Y - Y*
factor prices are assumed to adjust in response to output gaps in the adjustment process
factor prices are assumed to have
fully
adjusted to any output gap in the long run
inflationary and recessionary gaps
recessionary gap Y< Y*. costs / wages fall. U falls
inflationary gap Y > Y* Costs / wages rise. P rise
asymmetry of wage adjustment: flexible and sticky wages
Wage
flexible
downward. Aggregate consumption fall as wages fall. recessionary gap eliminated as SRAS shifts right
Wages
sticky
downward. Aggregate Consumption falls
slowly
as wages fall
slowly
. Y returns to Y* slowly -- economy "languishes" in recession
the phillips curve
is when the rate of change of wages
inversely
related to U-rate
potential output as an "anchor" for the economy
classical economists infer that there is an "automatic tendency for the economy to be at full-employment"
anchor: Y --> Y
automatically. beasically means that the Y will go back to Y
itself
Short-run versus long-run effects of AD and AS shocks
The adjustment in wages and other factor prices eventually eliminates any inflationary output gap caused by an AD shock; real GDP returns to its potential level
Fiscal stabilization policy
is fundamentally a short-run policy. In response to various shocks that cause changes in real GDP, the government may use various fiscal tools in an attempt to push real GDP back towards potential output
a reduction in tax rates or an increase in government purchases or transfers will shift the AD curve to the right, causing an increase in real GDP. An increase in tax rates or a cut in government purchases or transfers will shift the AD curve to the left, causing a decrease in real GDP
the paradox of thrift
the idea that an increase in desired saving reduces the level of real GDP -- is true only in the short run. In the long run, the Path of real GDP is determined by the path of potential output. The increase in saving has the long-run effect of increasing investment and therefore increasing potential output
decision lags and execution lags
decision lag: the period of time between perceiving some problem and reach ing a decision on what to do about it
execution lag: the time it takes to put policies in place after a decision has been made
automatic stabilizers
elements of the tax-and-transfer system that reduce the responsiveness of real GDP to changes in autonomous expenditure
fine tuning
the attempt to maintain output at its potential level of means of frequent changes in fiscal or monetary policy
gross tuning
the use of macroeconomic policy to stabilize the economy such that large deviations from potential output do not persist for extended periods of time