chapter 3

Economic States and Adjustment Process

Three macroeconomic states are identified: the Short Run, Adjustment Process, and Long Run, each with specific assumptions regarding factor prices and technology.

In the Short Run, factor prices are exogenous, and technology and factor supplies are constant, leading to real GDP being determined by aggregate demand (AD) and aggregate supply (AS). During the Adjustment Process, factor prices become flexible in response to output gaps. In the Long Run, factor prices fully adjust, while technology and factor supplies change, allowing potential GDP to grow.

Output Gap Dynamics

Output gaps are defined as the difference between actual output (Y) and potential output (Y). A recessionary gap occurs when Y < Y, and an inflationary gap occurs when Y > Y*. Wages and unit costs adjust based on these gaps, with wages rising during inflationary gaps and falling during recessionary gaps, albeit slowly due to downward wage stickiness.

The Phillips Curve reflects this adjustment process, showing the inverse relationship between unemployment and wage changes. The economy's adjustment back to Y* represents the long-term equilibrium where output equals potential output, indicating stability in factor prices.

Fiscal Stabilization Policy

Fiscal stabilization policy aims to mitigate economic volatility following AD or AS shocks. A recessionary gap can be addressed by rightward shifts in AD or AS, whereas an inflationary gap can be resolved by leftward shifts in AD or AS.

Discretionary fiscal policy involves active changes in government spending and taxation to influence GDP, while automatic stabilizers operate through tax and transfer systems that adapt to changes in income. Economists agree on the effectiveness of automatic stabilizers but caution against discretionary policy due to implementation lags and uncertainties.