Chapter 25

The Difference
between
Short-Run
and Long-Run
Macroeconomics

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 In this chapter you will learn to

1. Explain why economists think differently about short-run and

long-run changes in macroeconomic variables.

2. Describe how changes in GDP can be decomposed into changes

in factor supply, the utilization rate of factors, and productivity.

3. Explain why short-run changes in GDP are mostly caused by

changes in factor utilization, whereas long-run changes in GDP
are mostly caused by changes in factor supplies and productivity.

4. Explain why macroeconomic policies will have a long-run effect

on output only if they influence factor supplies or productivity.

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Two Examples

Inflation and Interest Rates in the United States

The Federal Reserve’s long-term objectives are a stable

overall price level, sustainable real GDP growth, and
“moderate” long-term interest rates.

However, the Federal Reserve has responded to an

inflationary gap by raising interest rates.

Do high interest rates and the recessionary gap created by

the Federal Reserve consistent with its goal?

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The Monetary Policy Puzzle

The key to this puzzle:

- recognize the different short-run and long-run effects
of monetary policy

In the short run, the rise in interest rates causes aggregate

expenditure to fall, reducing output.

But in the long run, the downward pressure on wages

(recessionary gap) causes inflation and interest rates to fall.

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Saving and Growth in Japan

For the decade following 1990, Japan’s economy was

stagnant. Some argue there was too much saving (and too
little spending).

Many also argue that Japan’s economic success since

World War II was due in part to its high saving rate.

How can both views be correct?

- recognize the different short-run and long-run
effects of saving

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Saving and Growth in Japan

In the short run, an increase in desired saving leads to less

aggregate desired spending  economic slump.

But in the long run, greater saving expands the pool of

funds, drives down interest rates, and makes investment
more attractive.

More investment in capital leads to increases in the

economy’s long-run productive potential  economic
growth.

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A Need to Think Differently

Short run:
- emphasize changes in output as deviations from
potential
- limited price and wage adjustment

Long run:
- emphasize changes in output as changes of potential
- considerable wage and price adjustment takes place

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Figure 25.1 Actual and Potential GDP
in the United States, 1975–2005

Accounting for Changes in GDP

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Different Types of Changes in
GDP
Figure 25.1 shows two types of changes in GDP:
1. some changes that involve departures of actual GDP
from potential GDP (e.g., B to C)
2. change in GDP that involves changes in potential GDP
(e.g., B to D)
Therefore, to study:
1. long-run trends: focus on the change in potential
output
2. short-run fluctuation: focus on the change in the output
gap
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GDP Accounting:
The Basic Principle

Consider the following identity:

GDP = F x (FE/F) x (GDP/FE)

• F is the amount of factors.

• FE is the amount of employed factors.

What are the three separate terms?

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GDP Accounting:
The Basic Principle

GDP = F x (FE/F) x (GDP/FE)

• F is the factor supply.

• FE/F is the factor utilization rate.
• GDP/FE is a simple measure of productivity.

Any change in GDP must be associated with a change in one

or more of these things.

How do these three components change over time?

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GDP Accounting:
The Basic Principle

1. Factor Supplies
- supplies of labor and capital change only gradually
- over time, their growth is considerable

 Changes in factor supply are important for explaining long-

run changes in output, but relatively unimportant in explaining
short-run changes.

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GDP Accounting:
The Basic Principle

2. Productivity
- productivity changes only gradually
- over time, productivity grows substantially

 Changes in productivity are important for explaining long-

run changes in output, but less important in explaining short-
run changes.

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GDP Accounting:
The Basic Principle

3. Factor Utilization
- fluctuates a lot in the short run in response to AD
or AS shocks
- fluctuates very little in the long run

 Changes in the factor utilization rate are important for

explaining short-run changes in output, but relatively
unimportant in explaining long-run changes in output.

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GDP Accounting: An Application

Consider just one factor of production — labor.

The identity becomes:

GDP = L x (E/L) x (GDP/E)

- L is the labor force
- E/L is the employment rate
- GDP/E is a simple measure of labor productivity

How have these components actually moved in the U.S.?

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Figure 25.2 Three Sources of
Changes in GDP
Upward Trend in the Labor Force

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Figure 25.2 Three Sources of
Changes in GDP
Upward Trend in the Productivity

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Figure 25.2 Three Sources of
Changes in GDP
Employment Rate

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 Summing Up
To understand long-run changes in GDP:
- need to understand labour force growth and
productivity growth

To understand short-run changes in GDP:

- need to understand changes in the utilization rate
of labor — the employment rate

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 Policy Implications

When studying short-run fluctuations, economist focus on:

– deviations of actual output from potential

When studying long-run changes, economist focus on:

– potential output

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 Policy Implications

Fiscal and monetary policies affect the short-run level of GDP

because they alter the level of aggregate demand.

But unless they are able to affect the level of potential output,
they will have no effect on long-run GDP.z
- broad consensus that monetary policy has only
limited effects on Y*
- fiscal policy probably has more effect on Y*

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 Looking Ahead

This chapter has focused on the difference between the

short run and the long run.

Short-run movements in GDP are mostly accounted for by

changes in the factor utilization rate.

Long-run changes in GDP are mostly accounted for by

changes in factor supplies and productivity.

This difference forces economists to think differently about

macroeconomic relationships that exist over a few months
as compared to those that exist over several years.
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