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

The output gap and factor prices

inflationary and recessionary gaps

asymmetry of wage adjustment: flexible and sticky wages

the phillips curve

potential output as an "anchor" for the economy

Short-run versus long-run effects of AD and AS shocks

Fiscal stabilization policy

the paradox of thrift

decision lags and execution lags

automatic stabilizers

fine tuning

gross tuning

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

is when the rate of change of wages inversely related to U-rate

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

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

recessionary gap Y< Y*. costs / wages fall. U falls

inflationary gap Y > Y* Costs / wages rise. P rise

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

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 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

elements of the tax-and-transfer system that reduce the responsiveness of real GDP to changes in autonomous expenditure

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

the attempt to maintain output at its potential level of means of frequent changes in fiscal or monetary policy

the use of macroeconomic policy to stabilize the economy such that large deviations from potential output do not persist for extended periods of time