From the Short Run to the Long Run

© 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e O’Sullivan/Sheffrin

Prepared by:

Fernando Quijano and Yvonn Quijano

C H A P T E R

29

From the Short RunFrom the Short Runto the Long Runto the Long Run


Monetary Policy in the Short Run

• In the short run, interest rates are In the short run, interest rates are determined by the supply and determined by the supply and demand for money. The Fed can demand for money. The Fed can change interest rates because it change interest rates because it controls the supply of money.controls the supply of money.


Short Run Versus Long Run

• In the long run:In the long run:• Prices are flexible.Prices are flexible.

• The level of GDP is determined by the demand and The level of GDP is determined by the demand and supply for labor, the stock of capital, and supply for labor, the stock of capital, and technological progress.technological progress.

• The economy operates at full employment.The economy operates at full employment.

• The supply of output is fixed.The supply of output is fixed.

• Any increases in government spending must come Any increases in government spending must come at the sacrifice of some other use of output.at the sacrifice of some other use of output.


Short Run Versus Long Run

• In the short run:In the short run:• Prices are primarily fixed. Short-run, Keynesian Prices are primarily fixed. Short-run, Keynesian

economics applies to the period of time when wages economics applies to the period of time when wages and prices do not change—at least not substantially.and prices do not change—at least not substantially.

• The level of GDP is determined by the total demand The level of GDP is determined by the total demand for goods and services.for goods and services.

• Increases in the money supply, government Increases in the money supply, government spending, or tax cuts will lead to an increase in GDP.spending, or tax cuts will lead to an increase in GDP.


Wage and Price Adjustments

• Wages and prices rise and fall together.Wages and prices rise and fall together.

• During booms, when GDP exceeds its full During booms, when GDP exceeds its full employment level, or potential output, wages employment level, or potential output, wages and prices tend to increase. Firms will offer and prices tend to increase. Firms will offer higher wages because it is more difficult to higher wages because it is more difficult to find, hire, and retain workers.find, hire, and retain workers.

• During recessions, when GDP falls below During recessions, when GDP falls below potential output, wages and prices will fall potential output, wages and prices will fall together.together.


Wage and Price Adjustments

• As prices rise, workers need higher nominal As prices rise, workers need higher nominal wages to maintain their real wage. This wages to maintain their real wage. This concept is associated with the reality principle:concept is associated with the reality principle:

RealityReality PRINCIPLEPRINCIPLEWhat matters to people is the real value of What matters to people is the real value of money or income–its purchasing power–not money or income–its purchasing power–not the face value of money or income.the face value of money or income.


The Wage-price Spiral

• The process by which rising wages cause The process by which rising wages cause higher prices and higher prices feed higher higher prices and higher prices feed higher wages is known as the wages is known as the wage-price spiralwage-price spiral..

• A wage-price spiral occurs when actual output A wage-price spiral occurs when actual output produced exceeds the potential output of the produced exceeds the potential output of the economy.economy.


Unemployment, Output,and Wage and Price Changes

Unemployment, Output, and Wage and Price ChangesUnemployment, Output, and Wage and Price Changes

When unemployment is When unemployment is below the natural ratebelow the natural rate

When unemployment is When unemployment is above the natural rateabove the natural rate

Output is above potentialOutput is above potential Wages and prices rise Wages and prices rise

Output is below potentialOutput is below potential Wages and prices fall Wages and prices fall

When output exceeds potential, wages and prices will rise above previous inflation rates. For example, if the economy had been experiencing 6% annual inflation, prices will rise at a rate faster than 6% per year.


Aggregate Demand,Aggregate Supply and Adjustment

• The The aggregate demand aggregate demand curvecurve is the relationship is the relationship between the price level and between the price level and the quantity of real GDP the quantity of real GDP demanded.demanded.



• There are two aggregate There are two aggregate supply curves:supply curves:

• The The classical aggregate classical aggregate supply curve,supply curve, or long-run or long-run aggregate supply, aggregate supply, represented as a vertical represented as a vertical line at the full-employment line at the full-employment level of output.level of output.



• There are two aggregate There are two aggregate supply curves:supply curves:

• The The Keynesian Keynesian aggregate supply curveaggregate supply curve. . A relatively flat supply A relatively flat supply curve that reflects the idea curve that reflects the idea that prices do not change that prices do not change very much in the short run very much in the short run and that firms adjust and that firms adjust production to meet production to meet demand.demand.



• In the short run, prices and In the short run, prices and output are determined output are determined where the aggregate where the aggregate demand curve intersects demand curve intersects the Keynesian aggregate the Keynesian aggregate supply curve, at point supply curve, at point AA..



• In the long run, the level In the long run, the level of prices and output is of prices and output is determined by the determined by the intersection of the intersection of the aggregate demand and aggregate demand and the classical aggregate the classical aggregate supply curve, at point supply curve, at point DD..


Adjustment to Long-run Equilibrium

• At point At point AA, output exceeds , output exceeds potential and the potential and the unemployment rate unemployment rate exceeds the natural rate. exceeds the natural rate. Firms find it difficult to hire Firms find it difficult to hire and retain workers and the and retain workers and the wage-price spiral begins.wage-price spiral begins.



• As the price level As the price level increases, the Keynesian increases, the Keynesian aggregate supply curve aggregate supply curve shifts up over time. shifts up over time. Eventually, the economy Eventually, the economy reaches point reaches point DD..

• At point At point DD, the economy , the economy reaches full employment reaches full employment and the adjustment stops.and the adjustment stops.



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

• Once the economy has Once the economy has made the transition to the made the transition to the long run, the result is, as long run, the result is, as predicted by the classical predicted by the classical model, that prices are model, that prices are higher and output returns higher and output returns to full employment.to full employment.



• If the level of output is If the level of output is below full employment, the below full employment, the adjustment process works adjustment process works in reverse.in reverse.

• The unemployment rate The unemployment rate exceeds the natural rate of exceeds the natural rate of unemployment. As wages unemployment. As wages and prices fall, the and prices fall, the aggregate supply curve aggregate supply curve shifts downward until the shifts downward until the economy returns to full economy returns to full employment.employment.


The Speed of Adjustmentand Economic Policy

• One alternative for policy One alternative for policy makers is to do nothing, makers is to do nothing, allowing the economy to allowing the economy to adjust itself, down to point adjust itself, down to point DD..

• Another is to use Another is to use expansionary policies to expansionary policies to shift the aggregate shift the aggregate demand curve to the right, demand curve to the right, up to point up to point EE. But, the . But, the price level is higher at price level is higher at point point EE than at point than at point DD..


The Speed of Adjustment and Economic Policy

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

• Economists who believe the economy adjusts Economists who believe the economy adjusts rapidly to full employment generally oppose using rapidly to full employment generally oppose using fiscal or monetary policy to try to stabilize the fiscal or monetary policy to try to stabilize the economy.economy.

• Economists who believe the economy adjusts slowly Economists who believe the economy adjusts slowly are more sympathetic to using stabilization polices.are more sympathetic to using stabilization polices.


A Closer Look atthe Adjustment Process

• Model of demand with money: At the current price level Model of demand with money: At the current price level PP00, the economy is producing at a level of output , the economy is producing at a level of output yy00 that that

is below full employment is below full employment yyFF..


Returning to Full Employment

• If prices are cut in half, the demand for money If prices are cut in half, the demand for money shifts leftward. Interest rates fall, investment shifts leftward. Interest rates fall, investment increases, and total demand shifts up.increases, and total demand shifts up.


Returning to Full Employment

• In sum, changes in wages and prices restore In sum, changes in wages and prices restore the economy to full employment through the economy to full employment through changes in the demand for money and changes in the demand for money and interest rates, followed by changes in interest rates, followed by changes in investment and the level of GDP.investment and the level of GDP.


Monetary Policy in theShort run and the Long run

• In the short run, an In the short run, an increase in the money increase in the money supply increases output supply increases output above potential (point above potential (point AA).).

• In the long run, the In the long run, the economy returns to full economy returns to full employment but at a employment but at a higher price level, at higher price level, at point point BB..


Long-run Neutrality of Money

• In the long run, changes in the money supply In the long run, changes in the money supply are “neutral” with respect to real variables in the are “neutral” with respect to real variables in the economy, that is, they have no effect on real economy, that is, they have no effect on real variables, only on prices.variables, only on prices.

• Money is, however, not neutral in the short run. Money is, however, not neutral in the short run. In the short run, changes in the money supply In the short run, changes in the money supply affect interest rates, investment spending, and affect interest rates, investment spending, and output.output.



• Monetary expansion that initially leads to output above Monetary expansion that initially leads to output above full employment, higher prices and wages, and higher full employment, higher prices and wages, and higher demand for money, eventually results in higher interest demand for money, eventually results in higher interest rates, lower investment, and a return to full employment.rates, lower investment, and a return to full employment.



• If every green dollar was replaced by two blue If every green dollar was replaced by two blue dollars, then:dollars, then:• Everyone would have twice as many blue dollars as Everyone would have twice as many blue dollars as

they formerly had of green dollars.they formerly had of green dollars.

• Prices and wages quoted in the blue currency would Prices and wages quoted in the blue currency would simply be twice as high as for the green dollars.simply be twice as high as for the green dollars.

• The purchasing power of blue money would be the The purchasing power of blue money would be the same as it was for green money, therefore, real same as it was for green money, therefore, real wages would be the same as before.wages would be the same as before.



• In the long run, the currency conversion has no In the long run, the currency conversion has no effect on the real economy, and will be neutral. effect on the real economy, and will be neutral. Prices adjust to the amount of nominal money Prices adjust to the amount of nominal money available.available.

• Whether the money comes from an open Whether the money comes from an open market purchase or a currency conversion, it market purchase or a currency conversion, it will be neutral in the long run.will be neutral in the long run.


Crowding Out in the Long Run

• Crowding outCrowding out is the reduction of investment (or other is the reduction of investment (or other component of GDP) in the long run caused by an component of GDP) in the long run caused by an increase in government spending.increase in government spending.



• Crowding out of investment spending in the long Crowding out of investment spending in the long run, translates into reduced capital deepening run, translates into reduced capital deepening and lower levels of real income and wages in and lower levels of real income and wages in the future.the future.

• Tax cuts can also crowd out investment in the Tax cuts can also crowd out investment in the long run. Tax cuts will lead to an increase long run. Tax cuts will lead to an increase consumption; a higher level of GDP; higher consumption; a higher level of GDP; higher prices, wages, and demand for money, thus prices, wages, and demand for money, thus higher interest rates.higher interest rates.



• Crowding inCrowding in is the increase of investment (or is the increase of investment (or other component of GDP) in the long run other component of GDP) in the long run caused by a decrease in government spending.caused by a decrease in government spending.

• The economy will experience increased capital The economy will experience increased capital deepening and higher levels of real income and deepening and higher levels of real income and wages in the future.wages in the future.


Political Business Cycles

• The The political business cyclepolitical business cycle describes the describes the effects on the economy of using monetary or effects on the economy of using monetary or fiscal policy to stimulate the economy before fiscal policy to stimulate the economy before an election to improve reelection prospects.an election to improve reelection prospects.

• The long run impact of expansionary policies The long run impact of expansionary policies to stimulate the economy before reelection to stimulate the economy before reelection are higher prices, or crowding out after are higher prices, or crowding out after reelection. Before the election, the economy reelection. Before the election, the economy booms; after the election, the economy booms; after the election, the economy contracts.contracts.

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From the Short Run to the Long Run

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