9.2 The Adjustment Process

Question 1

What relationships do we examin in order to develop our theory of the adjustment process?

Answer 1

We develop our theory of the adjustment process by examining the relationship among output gaps, factor markets, and factor prices.

Question 2

What do we call it when a nations actual output diverges from its potential output?

Answer 2

When a nation’s actual output diverges from its potential output, the difference is called the output gap.

Question 3

In this chapter, therefore, we view variations in the output gap as determined solely by variations in actual GDP around a constant level of potential GDP.

Why?

Answer 3

Although growth in potential output has powerful effects from one decade to the next, its change from one year to the next is small enough that we ignore it when studying the year-to-year behaviour of real GDP and the price level.

Question 4

Graphical versions of an output gap

Answer 4

Question 5

What is the output gap?

Answer 5

The output gap is the difference between actual GDP and potential GDP.

Question 6

How is potential output depicted on a graph?

Answer 6

Potential output is shown by the vertical line.

Question 7

Graphically, what does a recessionary gap and an inflationary gap look like?

Answer 7

A recessionary gap, shown in part (i), occurs when actual output is less than potential GDP. An inflationary gap, shown in part (ii), occurs when actual output is greater than potential GDP.

Question 8

We make two key assumptions in our macro model regarding factor prices and the output gap. What are they?

Answer 8

First, when real GDP is above potential output, there will be pressure on factor prices to rise because of a higher than normal demand for factor inputs.

Second, when real GDP is below potential output, there will be pressure on factor prices to fall because of a lower than normal demand for factor inputs.

These relationships are assumed to hold for the prices of all factors of production, including land, labour, and capital equipment.

Question 9

What happens when we are working above potential output?

Answer 9

Because firms are producing beyond their normal capacity output, there is an excess demand for all factor inputs, including labour.

Labour shortages will emerge in some industries and among many groups of workers.

Firms will try to bid workers away from other firms in order to maintain the high levels of output and sales made possible by the boom conditions.

Question 10

What behavior do workers and firms tend to exibit during when Y > Y*

Answer 10

As a result of this excess demand in factor markets, workers will find that they have bargaining power with their employers, and they will put upward pressure on wages.

Firms, recognizing that demand for their goods is strong, will be anxious to maintain a high level of output.

To prevent their workers from either striking or quitting and moving to other employers, firms will be willing to accede to some of these upward pressures.

Question 11

In conclusion, what does the boom accociated with an inflationay gap generate?

Answer 11

The boom that is associated with an inflationary gap generates an excess demand for factors that tends to cause wages (and other factor prices) to rise.

Question 12

What does an increase in factor prices associated with a boom do to unit costs and the AS curve? What is its affect on equilibrium real GDP?

Answer 12

This increase in factor prices will increase firms’ unit costs. As unit costs increase, firms will require higher prices in order to supply any given level of output, and the AS curve will therefore shift up.

This shift has the effect of reducing equilibrium real GDP and raising the price level. Real GDP moves back toward potential and the inflationary gap begins to close.

Question 13

What assumption do we make about factor prices during an inflationay gap?

Answer 13

In our model, factor prices are assumed to continue to rise as long as some inflationary gap remains.

In other words, they will continue rising until the AS curve shifts up to the point where the equilibrium level of GDP is equal to potential GDP.

At this point, there is no longer an excess demand for factors, no more pressure for factor prices to rise, firms’ costs are stable, and the AS curve stops shifting.

Question 14

What happens with firms and labour during a recessionary gap?

Answer 14

Because firms are producing below their normal capacity output, there is an excess supply of all factor inputs, including labour.

There will be labour surpluses in some industries and among some groups of workers.

Firms will have below-normal sales and not only will resist upward pressures on wages but also may seek reductions in wages.

Question 15

What does the slump that is associated with a recessionary gap generate?

Answer 15

The slump that is associated with a recessionary gap generates an excess supply of factors that tends to cause wages (and other factor prices) to fall.

Question 16

What is the effect on the reduction of unit costs on the AS curve and the real GDP equilibrium?

Answer 16

Such a reduction in factor prices will reduce firms’ unit costs.

As unit costs fall, firms require a lower price in order to supply any given level of output, and the AS curve therefore shifts down.

This shift has the effect of increasing equilibrium real GDP and reducing the price level.

Real GDP moves back toward potential and the recessionary gap begins to close.

Question 17

What is assumed to happen to factor prices and wages as long as some recessionary gap remains?

Answer 17

Wages and other factor prices are assumed to fall as long as some recessionary gap remains.
As factor prices fall, the AS curve shifts down, and this process continues until the equilibrium level of GDP is equal to potential output.
At this point, there is no longer an excess supply of factors, no more pressure for factor prices to fall, firms’ unit costs are stable, and the AS curve stops shifting.

Question 18

What is the concept of downward wage stickiness?

Answer 18

Both upward and downward adjustments to wages and unit costs do occur, but there are differences in the speed at which they typically operate. Booms can cause wages to rise rapidly; recessions usually cause wages to fall only slowly.

Question 19

What is the Phillips curve?

Answer 19

Using data from the late nineteenth and early twentieth centuries, when wages were more flexible than they are now, A.W.
Phillips observed that wages tended to fall in periods of high unemployment and rise in periods of low unemployment.

The resulting negative relationship between unemployment and the rate of change in wages has been called the Phillips curve ever since.

Question 20

Definition of the Phillips curve

Answer 20

Originally, a relationship between the unemployment rate and the rate of change of nominal wages. Now often drawn as a relationship between real GDP and the rate of change of nominal wages.

Question 21

What do we call the unemployment rate when

Answer 21

When output equals potential output the corresponding unemployment rate is sometimes called the natural rate of unemployment, and is denoted U*

Question 22

Where does the phillips curve cut the horizontal axis?

Answer 22

The Phillips curve cuts the horizontal axis at Y* (and at U* ).

Question 23

How is the phillips curve different then the AS sucve?

Answer 23

Note that the Phillips curve is not the same as the AS curve. The AS curve has the price level on the vertical axis whereas the Phillips curve has the rate of change of nominal wages on the vertical axis.

Question 24

How is the Phillips curve and the AS curve related?

Answer 24

How are the two curves related? The economy’s location on the Phillips curve indicates how the AS curve is shifting as a result of the existing output gap.

Question 25

What does the shape of the Phillips curve reflect?

Answer 25

It reflects the adjustment asymmetry we mentioned in the text.

The shape of the Phillips curve implies that an inflationary gap of a given amount will lead to faster wage increases than an equally sized recessionary gap will lead to wage reductions.

In other words, an inflationary gap will cause the AS curve to shift up more quickly than a recessionary gap will cause the AS curve to shift down.

Question 26

Why is it named an inflationary gap?

Answer 26

When real GDP exceeds potential GDP in our model, there will normally be rising unit costs, and the AS curve will be shifting upward. This will in turn push the price level up and create temporary inflation.

The larger the excess of real GDP over potential GDP, the greater the inflationary pressure. The term inflationary gap emphasizes this salient feature of the economy when .

Question 27

Why is it called a ressionary gap?

Answer 27

When actual output is less than potential output, as we have seen, there will be unemployment of labour and other productive resources. Unit costs will tend to fall slowly, leading to a slow downward shift in the AS curve. Hence, the price level will be falling only slowly so that unemployment will be the output gap’s most obvious result. The term recessionary gap emphasizes this salient feature that high rates of unemployment occur when .

Question 28

Why do we refer to potential output as an “Anchor” for the economy?

Answer 28

Following an AD or AS shock, the short-run equilibrium level of output may be different from potential output.

Any output gap is assumed to cause wages and other factor prices to adjust, eventually bringing the equilibrium level of output back to potential.

The level of potential output therefore acts like an “anchor” for the economy.

Question 29

What does a recessionarry gap lead to?

Answer 29

Question 30

What happens to firm and labor behavor in the face of an inflationary gap?

Answer 30

Real GDP Decreaces and Price level Increaces

AS curve shifts to the left

Question 31

What will happen to firms, labor and wages in the face of a recessionary gap?

Answer 31

Real GDP increaces
Price level decrease
AS curve shifts to the right

Question 32

In the face of an output gap, what direction does the AS curve shift?

Answer 32

The AS curve will shift in the direction of the potential output line.

Question 33

In the face of a negative demand shock, how will long run adjustment bring the equilibrium back to Potential? Whats a way they can do this?

Answer 33

Lower Wages

Question 34

Why may policymakers choose to use fiscal expansion to restore equilibrium back to potential GDP after a negative demand shock? What are delays in the shift of the AS curve caused by?

Answer 34

Question 35

Explain why wages rise when output is greater than potential but fall when output is less than potential.

Answer 35