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

Chapter 9: From the Short Run to the Long Run – The Adjustment of Factor Prices

Chapter Outline and Learning Objectives

This chapter explores the transition of the macroeconomy from the short run to the long run, focusing on the adjustment of factor prices and the implications for aggregate demand and supply. The main learning objectives are:

• Describe the three macroeconomic states and their underlying assumptions.

• Explain why output gaps cause wages and other factor prices to change.

• Describe how changes in factor prices affect firms' costs and shift the aggregate supply (AS) curve.

• Explain why real GDP gradually returns to potential output following aggregate demand (AD) or aggregate supply (AS) shocks.

• Describe the practical limitations on the use of fiscal stabilization policy.

Three Macroeconomic States

The Short Run

In the short run, the macroeconomic model makes specific assumptions about factor prices and technology:

• Factor prices are exogenous: Their values are determined outside the model and do not respond to changes in output within the short-run framework.

• Technology and factor supplies are constant: The productive capacity of the economy, denoted as Y* (potential output), does not change.

Example: If the price of labor (wages) increases, the short-run model does not explain why; it simply takes the change as given.

The Adjustment Process

The adjustment process describes how the economy responds to output gaps by allowing factor prices to change:

• Factor prices adjust in response to output gaps: When actual output deviates from potential output, wages and other input prices begin to change.

• Technology and factor supplies remain constant: The productive capacity does not change during the adjustment process.

Example: If real GDP exceeds potential output, wages may rise due to increased demand for labor.

The Long Run

In the long run, the model assumes full adjustment of factor prices and changing productive capacity:

• Factor prices are fully adjusted/endogenous: Wages and other input prices have responded completely to any output gap.

• Technology and factor supplies are changing: The economy's productive capacity (Y*) evolves over time, reflecting economic growth.

Example: Over several years, technological innovation increases potential output and changes wage levels.

Table 9-1: Three Macroeconomic States

	The Short Run	The Adjustment Process	The Long Run
Key Assumptions	Factor prices are exogenous. Technology and factor supplies (Y*) are constant/exogenous.	Factor prices are flexible/endogenous. Technology and factor supplies (Y*) are constant/exogenous.	Factor prices are fully adjusted/endogenous. Technology and factor supplies (Y*) are changing.
What Happens	Real GDP (Y) is determined by aggregate demand and aggregate supply.	Factor prices adjust to output gaps; real GDP eventually returns to Y*.	Potential GDP (Y*) grows over the long run.
Why We Study This State	To show the effects of AD and AS shocks on real GDP.	To see how output gaps cause factor prices to change and why real GDP tends to return to Y*.	To understand the nature of long-run economic growth.

The Adjustment Process

Output Gaps in the Short Run

Output gaps occur when actual real GDP (Y) differs from potential output (Y*):

• Recessionary output gap: Y < Y*. The economy is producing below its capacity.

• Inflationary output gap: Y > Y*. The economy is producing above its capacity.

These gaps are illustrated by shifts in the aggregate demand (AD) and aggregate supply (AS) curves, affecting the equilibrium price level and output.

Factor Prices and the Output Gap

Output Above Potential (Y > Y*)

• Excess demand for all factor inputs, including labor, leads to upward pressure on wages.

• Workers have increased bargaining power due to high demand for labor.

• Firms experience high profits and compete for scarce resources, causing wages to rise.

Example: During an economic boom, unemployment falls and wages increase as firms compete for workers.

Output Below Potential (Y < Y*)

• Excess supply of all factor inputs, including labor, leads to downward pressure on wages.

• Firms have below-normal sales and may seek wage cuts.

• Low profits and high unemployment cause wages to fall, but typically more slowly than they rise.

Example: In a recession, unemployment rises and firms may reduce wages or lay off workers.

Additional info:

• Aggregate Demand (AD) and Aggregate Supply (AS) Model: The AD-AS framework is central to understanding short-run fluctuations and long-run growth in macroeconomics.

• Potential Output (Y*): The level of output the economy can produce when operating at full capacity, without inflationary or recessionary pressures.

• Output Gap: The difference between actual output (Y) and potential output (Y*), indicating whether the economy is overheating or underperforming.

• Equation for Output Gap: $\text{Output Gap} = Y - Y^*$