From the Short Run to the Long Run: The Adjustment of Factor Prices (Macroeconomics Chapter 9 Study Notes)

Three Macroeconomic States

Overview of Economic States

Macroeconomics distinguishes between three main states of the economy: the short run, the adjustment process, and the long run. Each state is defined by the behavior of factor prices, technology, and factor supplies, which in turn affect real GDP and the aggregate supply curve.

• Short Run: Factor prices (such as wages) are assumed to be constant (exogenous). Technology and factor supplies are also constant.

• Adjustment Process: Factor prices become flexible/endogenous and adjust in response to output gaps, while technology and factor supplies remain constant.

• Long Run: Factor prices have fully adjusted (endogenous), and technology and factor supplies are changing, leading to growth in potential output.

Key Terms:

• Factor Prices: The prices paid for the use of factors of production, such as wages for labor and rents for capital.

• Potential Output (Y*): The level of real GDP that the economy can produce when operating at full employment, with all resources used efficiently.

Example: In the short run, a sudden increase in aggregate demand (AD) may raise output above potential, but factor prices remain unchanged until the adjustment process begins.

The Adjustment Process

Potential Output and the Output Gap

The adjustment process describes how the economy returns to its potential output (Y*) after a shock. The difference between actual output (Y) and potential output (Y*) is called the output gap:

$\text{Output Gap} = Y - Y^*$

• Recessionary Gap: When $Y < Y^*$, the economy is underperforming, with high unemployment and low demand for labor.

• Inflationary Gap: When $Y > Y^*$, the economy is overheating, with high demand for labor and rising wages.

Adjustment Mechanism:

• In a recessionary gap, low demand for labor leads to falling wages and lower unit costs, shifting the aggregate supply (AS) curve downward/rightward until output returns to $Y^*$.

• In an inflationary gap, high demand for labor leads to rising wages and higher unit costs, shifting the AS curve upward/leftward until output returns to $Y^*$.

Example: If the economy is in a recessionary gap, firms experience low profits and reduce hiring, causing wages to fall and the AS curve to shift, gradually closing the gap.

Aggregate Demand and Supply Shocks

Short-Run and Long-Run Effects

Aggregate demand (AD) and aggregate supply (AS) shocks can push output away from its potential level. The economy adjusts over time as factor prices respond to output gaps.

• AD Shock: A positive AD shock increases output and prices, creating an inflationary gap. Wages rise, shifting AS upward until output returns to $Y^*$.

• AS Shock: A negative AS shock (e.g., higher oil prices) raises costs and reduces output, creating a recessionary gap. Wages eventually fall, shifting AS downward until output returns to $Y^*$.

Adjustment Speed: The speed at which wages and factor prices adjust determines how quickly the economy returns to potential output. Wage stickiness can slow the adjustment, causing output gaps to persist.

Example: After a negative supply shock, such as a spike in oil prices, the economy may experience stagflation (high inflation and low output) until wages and other factor prices adjust downward.

Long-Run Equilibrium

Characteristics of Long-Run Equilibrium

In the long run, the economy reaches equilibrium when factor prices have fully adjusted and technology and factor supplies are changing. The long-run aggregate supply curve (LRAS) is vertical at $Y^*$, indicating that potential output is independent of the price level.

• Long-Run Aggregate Supply (LRAS): Vertical at $Y^*$, showing no relationship between price level and potential output.

• Determinants of Long-Run Growth: Changes in technology and factor supplies increase $Y^*$ over time.

Example: Economic growth in the long run is driven by increases in labor, capital, and technological progress, not by changes in aggregate demand.

Fiscal Stabilization Policy

Role and Limitations of Fiscal Policy

Fiscal stabilization policy aims to reduce volatility in aggregate outcomes by using government spending (G) and taxation (T) to influence aggregate demand. However, lags and uncertainty limit its effectiveness.

• Discretionary Fiscal Policy: Deliberate changes in G and/or T to steer real GDP.

• Automatic Stabilizers: Built-in features of the tax and transfer system that dampen the impact of shocks (e.g., progressive taxes, unemployment benefits).

• Limitations: Decision and execution lags, temporary vs. permanent changes, and the impossibility of fine-tuning the economy.

Formulas:

• Marginal Propensity to Spend: $z = MPC(1-t) - m$

• Simple Multiplier: $\text{Simple multiplier} = \frac{1}{1-z}$

Example: During the 2008-2009 recession, governments used fiscal stimulus (increased spending and tax cuts) to support aggregate demand and reduce unemployment.

Summary Table: Three Macroeconomic States

State	Factor Prices	Technology & Factor Supplies	Real GDP Determination	Purpose of Study
Short Run	Exogenous (constant)	Constant/exogenous	By AD and AS	Show effects of AD/AS shocks on real GDP
Adjustment Process	Flexible/endogenous	Constant/exogenous	Factor prices adjust to output gaps; GDP returns to $Y^*$	Show how output gaps cause factor prices to change
Long Run	Fully adjusted/endogenous	Changing	Potential output ($Y^*$) grows	Understand long-run economic growth

Key Diagrams and Relationships

Aggregate Demand and Supply Curves

• AD Curve: Shows the relationship between the price level and the quantity of real GDP demanded.

• AS Curve: Shows the relationship between the price level and the quantity of real GDP supplied.

• Short-Run Equilibrium: Intersection of AD and AS determines output and price level.

• Adjustment Process: Output returns to $Y^*$ as AS shifts in response to changing factor prices.

• Long-Run Equilibrium: Output is at $Y^*$, independent of price level.

Additional info: The Phillips curve summarizes the relationship between unemployment and wage inflation, indicating that output gaps drive changes in wages and prices.