Macroeconomic Adjustment: From Short Run to Long Run (Chapter 9 Study Notes)

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

Understanding Economic Adjustment

This topic explores how the economy returns to its normal state after being disturbed by shocks. The central question is: When the economy is pushed away from its normal output, how does it return? The process involves changes in wages and costs, which shift aggregate supply and restore equilibrium.

• Potential GDP (Y*): The economy's 'home point' or normal output level.

• At Y*:

  • Unemployment is at its natural rate ("normal").

  • Wages are stable.

  • Firms and workers are comfortable; there is no pressure for wages to rise or fall.

Output Gaps: When the Economy is "Off"

There are two main types of output gaps, each with distinct effects on wages, costs, and aggregate supply.

• Recessionary Gap (GDP < Y*)

  • Firms do not need as many workers; unemployment rises above normal.

  • Wages begin to fall due to excess labor supply.

  • Falling wages reduce firms' costs.

  • As costs fall, the Short-Run Aggregate Supply (SRAS) curve shifts right.

  • GDP returns to potential output (Y*).

  • The economy self-corrects over time.

• Inflationary Gap (GDP > Y*)

  • Firms need more workers; unemployment falls below normal.

  • Wages rise due to labor shortages.

  • Rising wages increase firms' costs.

  • As costs rise, the SRAS curve shifts left.

  • GDP returns to potential output (Y*).

  • The economy self-corrects over time.

The Adjustment Process: Sequence of Events

The adjustment from a shock to a new equilibrium follows a predictable sequence:

1. Aggregate Demand (AD) Shock occurs (e.g., change in investment, government spending, or consumer confidence).

2. Output Gap emerges (recessionary or inflationary).

3. Wages Adjust in response to unemployment deviations from normal.

4. SRAS Shifts as costs change.

5. GDP Returns to Y* (potential output).

Time Frames in Macroeconomic Adjustment

• Short Run: Wages are sticky (do not adjust quickly); GDP can move away from Y*.

• Adjustment Period: Wages begin to change in response to output gaps.

• Long Run: Wages have fully adjusted; GDP returns to Y*.

Worked Example: The Adjustment Cycle

Suppose business confidence rises, leading to increased investment:

1. AD shifts right (increase in aggregate demand).

2. GDP rises above Y* (inflationary gap forms).

3. Labor becomes scarce; wages rise.

4. Firms' costs rise; SRAS shifts left.

5. GDP returns to Y*, but the price level is now higher.

Fiscal Policy and the Adjustment Process

Fiscal policy refers to government actions (changing government spending or taxes) to help the economy return to Y* more quickly.

• In a recession: Increase government spending (G) or cut taxes to boost aggregate demand.

• In inflation: Decrease government spending or raise taxes to reduce aggregate demand.

• Note: Even without fiscal policy, wage adjustments will eventually restore equilibrium. Fiscal policy simply accelerates the process.

Core Concept to Remember

• Output gaps (deviations from Y*) cause wage changes.

• Wage changes shift the SRAS curve.

• SRAS shifts return GDP to potential output (Y*).

Summary Table: Output Gaps and Adjustment

Type of Gap	GDP Relative to Y*	Unemployment	Wage Response	SRAS Shift	Result
Recessionary Gap	Below Y*	Above normal	Wages fall	Right	GDP returns to Y*
Inflationary Gap	Above Y*	Below normal	Wages rise	Left	GDP returns to Y*

Key Equations

• Potential Output (Y*): The level of real GDP when all resources are fully employed at their normal rates.

• Aggregate Supply (AS) and Aggregate Demand (AD) determine equilibrium output and price level in the short run.

• SRAS Adjustment: Wage changes shift SRAS until output returns to Y*.

Additional info: The Phillips Curve, which relates unemployment and inflation, is also relevant to this topic, as wage adjustments affect inflation rates over time.