Chapter 24

From the Short

Run to the Long
Run: The
Adjustment of
Factor Prices

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 In this chapter you will learn to

1. Explain why output gaps cause wages and other factor

prices to change.

2. Describe how induced changes in factor prices affect firms’

costs and cause the AS curve to shift.

3. Explain why real GDP gradually returns to potential output

following an AD or AS shock.

4. Explain why lags and uncertainty place limitations on the

use of fiscal stabilization policy.
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The Short Run and the Long Run

The Short Run

• factor prices are assumed to be constant
• technology and factor supplies are assumed to be
constant
The Adjustment of Factor Prices
• factor prices are flexible
• technology and factor supplies are constant
The Long Run
• factor prices have fully adjusted
• technology and factor supplies are changing
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Table 24.1 Time Spans in
Macroeconomic Analysis

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Figure 24.1 Output Gaps in
the Short Run
Potential Output and the Output Gap

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Factor Prices and the Output Gap

When Y > Y*, the demand for labor (and other factor services)
is relatively high:
- an inflationary output gap

During an inflationary output gap there are high profits for

firms and unusually large demand for labor:
- wages and unit costs tend to rise

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Factor Prices and the Output Gap

When Y < Y*, the demand for labor (and other factor services)
is relatively low:
- recessionary output gap

During a recessionary gap there are low profits for firms and
low demand for labor
- wages and unit costs tend to fall (assuming no
inflation and productivity growth)

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Factor Prices and the Output Gap

Adjustment asymmetry:
- inflationary output gaps typically raise wages rapidly

- recessionary output gaps often reduce wages only

slowly

This general adjustment process — from output gaps to

factor prices — is summarized by the Phillips curve.

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The Phillips Curve

The Phillips curve was originally drawn as a negative relationship

between the unemployment rate and the rate of change in
nominal wages.
Y > Y* => excess demand for labor => wages rise
Y < Y* => excess supply for labor => wages fall
Y = Y* => no excess supply/demand => wages constant

EXTENSIONS IN THEORY 24.1

The Phillips Curve and the Adjustment
Process

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Potential Output as an “Anchor”

Suppose an AD or AD shock pushes Y away from Y* in the

short run.

As a result, wages and other factor prices will adjust, until Y

returns to Y*.
- Y* is an “anchor” for output

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Figure 24.2 The Adjustment Process
Following a Positive Aggregate Demand
Shock

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Figure 24.3 The Adjustment Process
Following a Negative Aggregate Demand
Shock

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Figure 24.4 The Adjustment Process
Following a Negative Aggregate Supply
Shock
Aggregate Supply Shocks

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It Matters How Quickly Wages
Adjust!

Following either a demand or supply shock, the speed with

which output returns to Y* depends on wage flexibility.

Flexible wages provide an adjustment process that quickly

pushes the economy back toward potential output.

But if wages are slow to adjust (sticky), the economy’s

adjustment process is sluggish and thus output gaps tend to
persist.

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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:
 Y = Y*

The vertical line at Y* is sometimes called:

- the long-run aggregate supply curve
- the Classical aggregate supply curve

There is no relationship in the long run between the price

level and potential output.

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Figure 24.5 Changes in
Long-Run Equilibrium

In the long run, Y is

determined only by potential
output — aggregate demand
determines P.

For a given AD curve,

long-run growth in Y*
results in a lower price
level.

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Fiscal Stabilization Policy

The Basic Theory of Fiscal Stabilization

The motivation for fiscal stabilization policy is to reduce the
volatility of aggregate outcomes.

A reduction in tax rates or an increase in government

purchases shifts the AD curve to the right, causing an
increase in real GDP.

An increase in tax rates or a cut in government purchases

shifts the AD curve to the left, causing a decrease in real
GDP.
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Figure 24.6 The Closing of a
Recessionary Gap

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Figure 24.7 The Closing of an
Inflationary Gap

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 The Paradox of Thrift

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

reduction in GDP — and possibly no change in aggregate
saving!

In the long run, an increase in desired saving has the

following effects:
- the price level falls
- investment rises
- aggregate output returns to Y*

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 The Great Depression

LESSONS FROM HISTORY 24.1

Fiscal Policy in the Great Depression

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Automatic vs. Discretionary
Fiscal Policy

Discretionary fiscal stabilization policy occurs when the

government actively changes G and/or T in an effort to affect
real GDP.

Automatic fiscal stabilization occurs because of the design

of the tax and transfer system (T = tY):
- as Y changes, transfers and taxes both change
- reduces the size of the simple multiplier
- dampens the output response to shocks

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Practical Limitations of Discretionary
Fiscal Policy
Most economists agree that automatic fiscal stabilizers are
desirable and generally work well, but they have concerns
about discretionary fiscal policy.

Limitations come from:

• long and uncertain lags

• temporary versus permanent changes in policy
• the impossibility of “fine tuning”

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Policy Lags

• decision lag – time between perceiving the problem

and reaching a decision
• execution lag – time to put policies in place after a
decision has been made

Temporary versus Permanent Tax Changes

• tax changes expected to be temporary are less

effective than those expected to be permanent

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The Role of Discretionary Fiscal
Policy

Fine tuning is the use of policy to offset virtually all

fluctuations in private-sector spending in order to keep real
GDP at or near its potential level.

Fine tuning is difficult. Nevertheless, many economists still

argue that when an output gap is large and persistent
enough, gross tuning may be appropriate.

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Fiscal Policy and Growth

Fiscal stabilization policy will generally have consequences

for economic growth.

For example:
• an increase in G temporarily increases real GDP
• investment is lower in the new long-run equilibrium
• this may reduce the rate of growth of potential output

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