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

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From the Short Run to the Long Run: The Adjustment of Factor Prices

Short-Run vs. Long-Run Adjustment

The transition from the short run to the long run in macroeconomics is primarily driven by the adjustment of factor prices, especially wages. This process explains how the economy returns to its potential output after experiencing shocks.

Short Run: Wages are sticky (do not adjust quickly), and firms' production costs remain relatively constant.
Long Run: Wages and other factor prices become flexible, allowing production costs to adjust. The Short-Run Aggregate Supply (SRAS) curve shifts until output returns to potential GDP (denoted as Y*).

Key Point: The adjustment from the short run to the long run occurs because factor prices are flexible in the long run.

Adjustment Asymmetry and Sticky Wages

Wages do not adjust symmetrically during economic fluctuations. This phenomenon is known as sticky wages.

During Slumps (Recessions): Wages adjust downward slowly because workers resist wage cuts.
During Booms (Expansions): Wages rise more quickly as firms compete for scarce labor.

This asymmetry helps explain why recessions can be prolonged compared to expansions.

Recessionary Output Gap

A recessionary gap occurs when actual GDP is less than potential GDP (Y < Y*).

High unemployment leads to an excess supply of labor.
Downward pressure on wages emerges.
As wages fall, firms' production costs decrease, causing the SRAS curve to shift rightward.

Example: If the economy is producing below its potential, unemployment rises, and over time, wages decrease, making it cheaper for firms to hire workers and produce more, which helps restore output to potential GDP.

Adjustment Process: Step-by-Step

When actual GDP is lower than potential GDP, the following sequence occurs:

A recessionary gap develops.
There is an excess supply of labor.
Wages begin to fall (slowly, due to sticky wages).
Firms accept lower prices for their products.
The SRAS curve shifts rightward, moving the economy back toward potential GDP.

Note: Downward wage adjustment is slower than upward wage adjustment during an inflationary gap, due to sticky wages.

Aggregate Demand (AD) Stability and the Multiplier

The multiplier measures how changes in autonomous spending affect overall GDP. The size of the multiplier influences the slope of the AD curve and the stability of GDP.

Large multiplier: AD curve is flatter; GDP is less stable during Aggregate Supply (AS) shocks.
Small multiplier: AD curve is steeper; GDP is more stable.

Automatic stabilizers (such as income taxes and government transfers) reduce the multiplier, making GDP more stable in response to shocks.

AD-AS Diagram Interpretation: Negative AS Shock

A negative Aggregate Supply (AS) shock (such as a sudden increase in oil prices) shifts the AS curve to the left.

Prices rise (inflation).
Output falls (recessionary gap).

This results in higher unemployment and downward pressure on wages over time.

Fiscal Policy: Closing the Output Gap

When output is below potential, fiscal policy can be used to close the gap by increasing Aggregate Demand (AD).

Increasing government spending (G), consumption (C), investment (I), or exports (X) can shift AD rightward.
Example: Policies that increase exports help close a recessionary gap.

The Phillips Curve

The Phillips curve describes the relationship between unemployment and wage growth (or inflation).

Typically, lower unemployment is associated with higher wage growth and inflation, and vice versa.

Summary Table: Short Run vs. Long Run Adjustment

Situation	Labour Market Condition	Wage Adjustment	SRAS Shift	Output
Recessionary Gap	Excess supply of labour	Wages fall (slowly)	Rightward	Returns to Y*
Inflationary Gap	Labour shortage	Wages rise (quickly)	Leftward	Returns to Y*

Key Equations

Potential GDP:
Multiplier Formula:
Aggregate Demand:

Big Picture Summary

Short run: Wages are sticky; output gaps (recessionary or inflationary) can exist.
Recessionary gap: Excess labour, wages fall slowly, SRAS shifts right.
Inflationary gap: Labour shortage, wages rise faster, SRAS shifts left.
Long run: Output returns to potential GDP as factor prices adjust.