Long-Run Self-Adjustment

Unit 3: National Income and Price Determination

Topic 3.7 - Long-Run Self-Adjustment

Overview

  • Focuses on the dynamics between short-run and long-run adjustments in the economy, particularly in relation to national income and price determination.

Differences Between Short-Run and Long-Run

  • In the Short-Run:

    • Wages and resource prices are sticky, meaning they WILL NOT change when the price level changes.

  • In the Long-Run:

    • Wages and resource prices are flexible, meaning they WILL change in response to changes in the price level.

Impact of Consumer Spending on GDP and Price Levels

  • Increase in Consumer Spending:

    • Short-Run Effects:

    • Aggregate Demand (AD) increases, leading to an increase in GDP and price levels.

    • Graphically: Shift from AD1 to AD2 leads to output moving from Q1 to Q2 and price level rising from PL1 to PL2.

    • Long-Run Effects:

    • Eventually, as wages and costs increase, the Aggregate Supply (AS) adjusts to reflect higher costs and wages, resulting in a return to a new long-run equilibrium at a higher price level (PL2), while output (Y) remains the same due to the vertical nature of the Long-Run Aggregate Supply (LRAS).

  • Decrease in Consumer Spending:

    • Short-Run Effects:

    • AD decreases, leading to a decrease in GDP and price levels.

    • Graphically: Shift from AD1 to AD2 leads to output dropping from Q1 to Q2 and price level dropping from PL1 to PL2.

    • Long-Run Effects:

    • Eventually, wages and costs decrease as firms adjust, shifting the AS curve rightwards, which leads to a new equilibrium with lower price levels but unchanged output.

Reactions to Consumer Spending Changes

  1. Scenario: Increase in Consumer Spending

    • Short-Run: Price levels (PL) and output (Q) increase.

    • Long-Run: Price level increases; output remains unchanged.

  2. Scenario: Decrease in Consumer Spending

    • Short-Run: Price level decreases; output remains unchanged in the long run.

Graphical Representations

  • Long-Run Equilibrium:

    • In a typical graph depicting Aggregate Demand and Aggregate Supply, the intersection of AD and AS curves determines the equilibrium price level and output.

  • Shifts in Curves:

    • Understand that shifts of the AD curve to the right or left represent changes in spending behaviors, and the long-run adjustments occur through shifts in AS.

Economic Growth Discussions

  • Concept of Economic Growth:

    • Covered in more detail in Unit 5 (Topics 5.6 and 5.7).

    • Discussed in relation to production possibilities curves and the effects of consumer spending and investment on economic potential.

    • Investment (e.g., purchase of capital stock like machinery and tools) is critical for growth, not just consumption or government spending.

Exam Practice Questions

  1. 2008 Audit Exam (Graph Interpretation):

    • Identifying long-run equilibria and shifts based on aggregate supply and demand dynamics.

  2. 2012 FRQ #3: Questions about impacts of increases in exports and nominal wage rigidities, requiring students to illustrate shifts in curves and discuss short-run and long-run outcomes.

Insights on Wage Dynamics

  • Current Economic Context:

    • Discussion surrounding the lack of wage increases despite high output levels, possibly reflecting structural or market rigidities.

Important Notes**

  • The understanding of economic dynamics requires connecting short-term changes to long-term adjustments to properly analyze policy implications and outcomes.

  • Grasping the flexibility of prices and wages is crucial for predicting adjustments in the economic landscape, particularly in reaction to various consumer and business spending behaviors.