Macro 3.7 - Long-Run Adjustment

Long Run Adjustments in the ASAD Model

Introduction

• Focus on long run adjustments within the Aggregate Supply-Aggregate Demand (ASAD) model.

• Importance of understanding differences between short run and long run in macroeconomics.

• Recommendation for further study: Total Review Booklet at ReviewEcon.com.

Short Run vs. Long Run

Definitions

• Short Run: Wages and resource prices are 'sticky' and do not change in response to price level changes.

  • Example: If there's a 20% inflation rate, wages remain the same initially.

• Long Run: Wages and resource prices are flexible and will adjust to changes in the price level.

  • Example: Following the same inflation, wages would eventually increase by 20%.

Key Concepts

• The distinction is not based on specific time frames but rather on how quickly prices adjust to changes in the economy.

• Short Run Aggregate Supply Curve: Upward sloping, reflecting tight relationship between price level and real GDP output due to sticky wages.

• Long Run Aggregate Supply Curve: Vertical, indicating that the economy will produce at the full employment level of output regardless of price level.

Graphical Representations

Short Run Equilibrium and Gaps

• Recessionary Gap:

  • Current equilibrium point lies left of the long run aggregate supply curve.

  • Indicates an unemployment rate greater than the natural rate of unemployment.

• Inflationary Gap:

  • Current output is greater than potential GDP; equilibrium point lies to the right of the long run aggregate supply curve.

  • Indicates an unemployment rate lower than the natural rate.

Transitioning from Short Run to Long Run Equilibrium

• From Recessionary Gap to Full Employment:

  • Increased unemployment leads workers to accept lower wages.

  • Result: Shift of short run aggregate supply curve to the right.

  • Outcome: Price level decreases, and quantity of output increases to the full employment level of output (Y_F).

• From Inflationary Gap to Full Employment:

  • Overworked workers demand higher wages, increasing input costs for businesses.

  • Result: Leftward shift of the short run aggregate supply curve.

  • Outcome: Increased price level, returning to full employment output (Y_F).

Dynamics of Aggregate Demand and Short Run Equilibrium

Rightward Shift in Aggregate Demand

• Increase in consumer confidence shifts aggregate demand curve right.

• Outcome:

  • Creates an inflationary gap.

  • Price level rises while real output increases temporarily.

• Closing the inflationary gap in the long run results in higher wages & input costs, shifting the short run aggregate supply curve left again to full employment output.

Negative Supply Shock Effects

• Events like increased oil prices cause a leftward shift in the short run aggregate supply curve.

• Results in:

  • Higher price levels with higher unemployment (cost-push inflation or stagflation).

• Eventually leads to a rightward adjustment as lower wages reduce input costs, restoring full employment.

Self-Adjustment Mechanism

• Long run adjustments occur without government intervention.

• Economy naturally returns to equilibrium over time when wages adjust based on market conditions.

Economic Growth in the Long Run

Key Definitions

• Economic Growth: Not merely an increase in real GDP, but an increase in potential real GDP.

• Influenced by:

  • Increases in labor quantity/quality.

  • Productivity advancements and technological improvements.

Graphical Representation of Economic Growth

• Economic growth appears as a rightward shift in the long run aggregate supply curve.

• This shift will eventually result in a similar shift for the short run aggregate supply curve as conditions stabilize.

Conclusion

• Recap of the importance of understanding the ASAD model and long run adjustments.

• Reminder to utilize ReviewEcon.com for additional study resources.

• Encouragement to prepare effectively for macroeconomics exams.