15.1 Linking to the Short Run and the Long Run

The Difference Between the Short and Long Run

• Short-run in macroeconomics: The period of time in which prices do not change or do not change very much.

• Long run in macroeconomics: The period of time in which prices have fully adjusted to any economic changes.

Wages and Prices and Their Adjustment Over Time

• Wages and prices will all tend to increase together during booms when GDP exceeds its full-employment level or potential output.

• Wages and prices will fall together during periods of recessions when GDP falls below full employment or potential output.

• To attract workers and prevent them from leaving, firms will raise their wages.

• Wage-price spiral: The process by which changes in wages and prices cause further changes in wages and prices.

• When the economy is producing below full employment or potential output, the process works in reverse.

15.2 How Wage and Price Changes Move the Economy Naturally Back to Full Employment

• Aggregate Demand Curve: A curve shows the relationship between the level of prices and the quantity of real GDP demanded.

• Short-run aggregate supply curve: A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.

• Long-run aggregate supply curve: A vertical aggregate supply curve that reflects the idea that in the long run, output is determined solely by the factors of production and technology.

Returning to Full Employment from a Recession

• With employment at the natural rate, the downward wage-price spiral ends.

• The economy has made the transition in the long run.

• Prices are lower and output returns to full employment.

Returning to Full Employment from a Boom

• If the output is less than full employment, prices will fall as the economy returns to full employment,

• If output exceeds full employment, prices will rise and output will fall back to full employment.

Economic Policy and the Speed of Adjustment

• Move from short run to long run:

  • One alternative for policymakers is to do nothing, allowing the economy to adjust itself with falling wages and prices until it returns by itself to full employment.

  • Another alternative is to use expansionary policies, such as open market purchases by the Fed or increases in government spending and tax cuts.

  • Demand policies can also prevent a wage-price spiral from emerging if the economy is producing at a level of output above full employment.

• Active economic policies are more likely to destabilize the economy if the adjustment is quick enough.

Liquidity Traps or Zero Lower Bound

• Liquidity trap: A situation in which nominal interest rates are so low, they can no longer fall; also known as the zero lower bound.

Political Business Cycles

• Political business cycle: The effect on the economy of using monetary or fiscal policy to stimulate the economy before an election to improve reelection prospects.

15.3 The Economics Behind the Adjustment Process

• Lower interest rates stimulate investment spending and push the economy back toward full employment. All this works in reverse if output exceeds the economy’s potential output.

• Why changes in wages and prices restore the economy to full employment:

  • Changes in wages and prices change the demand for money

  • This changes interest rates, which then affect aggregate demand for goods and services and ultimately GDP.

The Long-Run Neutrality of Money

• Long-run neutrality of money: A change in the supply of money has no effect on real interest rates, investment, or output in the long run.

Crowding Out in the Long Run

• The increase in government spending has no long-run effect on the level of output, only on the interest rate.

• If the government spending went toward government investment projects, then it will have just replaced an equivalent amount of private investment.

• Tax cuts initially will increase consumer spending and lead to a higher level of GDP. In the long run, however, adjustments in wages and prices restore the economy to full employment.

15.4 Classical Economics in Historical Perspective

• The term classical economics refers to the work of the originators of modern economic thought.

Say’s Law

• Classical economics is often associated with Say’s law, the doctrine that “supply creates its own demand.”

• Spending on consumption and investment together would be sufficient so that all the goods and services produced in the economy would be purchased.

• Keynes argued that there could be situations in which total demand fell short of total production in the economy for extended periods of time.

Keynesian and Classical Debates

• If wages and prices are not fully flexible, then Keynes’s view that demand could fall short of production is more likely to hold true.

• Patinkin and Modigliani, there is insufficient aggregate demand to restore the economy to full employment.