Chapter 24 Flashcards
describe an overview of the short and long runs and the adjustment of factor prices
Short Run:
determine Y–> factor prices and technology constant
Adjustment process:
Y eventually returns to Y* –>factor prices adjust
and technology remains constant
Long run:
changes in Y* determine changes in Y –>factor prices have adjusted and technology changes
What happens when Y> Y*
the demand for labour (and other factor services) is relatively high
• an inflationary output gap
During an inflationary output gap there are high profits for firms
and unusually large demand for labour
• wages and unit costs tend to rise
What happens to close the inflationary gap (describe process)?
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 –> AS shifts up
Y moves back towards Y* –> inflationary gap begins to close
What happens when Y < Y*?
the demand for labour (and other factor services) is relatively low
• recessionary output gap
During a recessionary gap there are low profits for firms and low
demand for labour
• wages and unit costs tend to fall
What happens to close the recessionary gap? (describe process)
This reduction in factor prices will reduce firms’ unit costs –> As unit
costs decrease firms will require lower prices in order to supply any given level of output –> AS shifts down
Y moves back towards Y* –> recessionary gap begins to close
Describe adjustment asymmetry:
• inflationary output gaps typically raise wages rapidly
• recessionary output gaps often reduce wages only slowly
(downward wage stickiness)
The general adjustment process is summarized by what?
This general adjustment process—from output gaps to factor
prices—is summarized by the Phillips curve.
describe the Philips curve
The Phillips curve was originally drawn as a negative relationship
between the unemployment rate and the rate of change in nominal
wages.
Y > Y* => excess demand for labour => wages rise
Y < Y* => excess supply for labour => wages fall
Y = Y* => no excess supply/demand => wages constant
describe Y* as an “anchor” for output
Suppose an AD or AS shock pushes Y away from Y* in the short run.
As a result, wages and other factor prices will adjust, until Y returns
to Y. => Y is an “anchor” for output
what does the economy’s adjustment process do with expansionary AD shocks?
The economy’s adjustment process eventually eliminates any boom caused by a demand shock, returning Y to Y*.
describe an expansionary AD shock and the economy’s response
There is an increase in autonomous expenditure
• AD shifts up: price increases and level of GDP increases
•An inflationary gap opens up
- Wages increases
- AS begins to shift up
- Prices increase and GDP reduces – back to Y*
- The inflationary gap is being removed
T or F: The economy’s adjustment process works following negative demand shocks typically faster than following positive demand shocks
False:
it may be
slower because of
“sticky wages”
describe speed of the adjustment: if wages are flexible
wages will fall rapidly whenever there is
unemployment, the resulting shift in the AS curve could quickly eliminate recessionary gaps.
describe speed of the adjustment: if wages are sticky
AS curve shifts more slowly. In such cases the recessionary gap may have to be closed with an expansion in AD (increase in private sector demand or government stabilization
policy).
describe a negative supply shock and the adjustment process
After a negative supply shock, the adjustment of factor prices reverses the AS shift and returns real GDP to Y*
Assume there is an increase in the price of oil.
•AS shifts up, prices increase and GDP falls (stanflation).
•A recessionary gap opens
up.
•Excess supply of labour: eventually pushes wages down (speed?) •AS shifts back towards its starting point. •NOTE: Relative prices have changed!!
what does the speed that output returns to Y* depend on with either a demand or supply shock?
wage flexibility
flexible wages provide an adjustment process that _______
quickly pushes
the economy back toward potential output.
if wages are slow to adjust, the economy’s adjustment process is ___________
sluggish and thus output gaps tend to persist
Describe the business cycle dynamics and their role in bringing the economy back to Y=Y*
When Y > Y* => shortages eventually arise and restrict further expansion
=> revision of firm’s expectations, reduce desired investment => Reduction of consumer’s confidence, reduce desired consumption
==> Real GDP tends to move back toward Y*
When Y < Y* =>consumer’s durable goods become obsolete =>normal
replacement expenditure recover. Firm’s replacement investment also recover => Revival of favorable expectations
==>Real GDP rises back toward Y*
when is the economy in a state of long-run equilibrium?
when factor prices are no longer adjusting to output gaps:
==> Y=Y*
what is the vertical line at Y* sometimes called?
- the long-run aggregate supply curve, or
* the classical aggregate supply curve
T or F: there is no relationship in the long run between the price level and potential output
True
in the long run, Y is determined only by
____________ —
aggregate demand
determines _______
determined only by potential output
AD determines P
For a given AD curve,
long-run growth in Y*
results in a _______
price level
lower
what is the motivation for fiscal stabilization policy?
to reduce the volatility of aggregate outcomes
when an AD or AS shock pushes Y away from Y*, what are the alternatives?
use fiscal stabilization policy
• wait for the recovery of private sector demand
=> a shift in the AD curve
• wait for the economy’s adjustment process
=> a shift in the AS curve
How may a recessionary gap be closed?
A recessionary gap may be closed by a (possibly slow) rightward shift in the AS curve or by a rightward shift in AD.
how may an inflationary gap be removed?
An inflationary gap may be removed by a leftward shift of AS or
by a leftward shift in AD.
Describe the basic theory of fiscal stabilization
A recessionary gap may be closed by:
- a rightward shift in AD due to recovery of private sector demand
- a (possibly slow) rightward shift in the AS curve
- a rightward shift in AD due to an expansionary fiscal policy
what is the main advantage of fiscal stabilization?
: it may shorten what might otherwise be a long recession
what is the main disadvantage of fiscal stabilization?
may stimulate the economy before private-sector
recovery and economy may overshoot its Y*=> creating instability
describe the paradox of thrift
In the short run, an increase in desired saving leads to a reduction in GDP (shift AD to the left and reduce GDP).
==> What may be good for any individual when viewed in isolation ends up being undesirable for the economy as a whole.
==>Major and persistent recession can be battled by encouraging
governments, firms and households to increase their spending.
does the paradox of thrift apply in the long run?
NO
==> In the long run AD does not influence the level of GDP.
==>The increase in savings has the long-run effect of increasing investment and therefore increasing potential output
def. discretionary fiscal stabilization policy
occurs when the government
actively changes G and/or T in an effort to steer real GDP.
def. automatic fiscal stabilization
occurs because of the design of the tax
and transfer system:
• as Y changes, net tax revenue changes
• the size of the simple multiplier is reduced
• the output response to shocks is dampened
The marginal propensity to spend on national income is:
z = MPC(1 – t) – m
The simple multiplier is:
Simple multiplier = 1/ (1 – z)
**The lower is the net tax rate (t), the larger is the simple multiplier
and thus the less stable is real GDP in response to shocks to
autonomous spending.
what are the main limitations of discretionary fiscal policy
- long and uncertain lags
- temporary versus permanent changes in policy
- the impossibility of “fine tuning”
describe uncertain lags with regards to discretionary fiscal stabilization policy
• Decision lags: the period of time between perceiving some
problem and reaching a decision on what to do about it.
• Execution lag: the time that it takes to put policies in place after a
decision has been made.
• And when the new policies are in place it can still take time for
their economic consequences to be felt.
==>It is possible that by the time a given policy decision has any
impact on the economy, circumstances will have changed such that
the policy is no longer appropriate
______ changes in taxation are generally less effective than
measures that are expected to be ____
temporary less than permanent
more ______ are households, the smaller will be the effects of what are perceived to be temporary changes in taxes
forward-looking
def. fine tuning
: the attempt to maintain output at its potential level by
means of frequent changes in fiscal policy.
def. gross tuning
: the use of macroeconomic policy to stabilize the economy such that large deviations from potential output do not persist for extended periods of time
what will an increase in G do with regards to economic growth
• An increase in G temporarily increases real GDP
• Adjustment: Y will return to Y* but at a higher prices
• GDP composition will be altered: Y = Ca +Ia +Ga +NXa
–Problem if investment is lower in the new long-run equilibrium
• Slower rate of accumulation of capital. This may reduce the rate of
growth of potential output.
what will a decrease in t do with regards to economic growth
• A decrease in t temporarily increases real GDP
• Adjustment: Y will return to Y* but at a higher prices
• Long-run effect: e.g: lower corporate income-tax rates make
investment more profitable to firms
• Any increase in investment will tend to increase the future growth
rate of potential output.
• It appears to be no trade-off between short and long run
Fiscal policy : increase in G general effects/considerations
The short-run stimulative benefits of the fiscal
expansion need to be weighted against the possible long-run costs of lower
growth.
But, some of the rise in G may be government investment. Then, the overall effect on the path of Y* depends on the productivity of public investment compared with the private investment that was crowded out.
fiscal policy: decrease in t general effects/ considerations
It appears to be no trade-off between short and long run.
But, this means less public spending on many of the things that citizens
value: national parks, public education, health care, roads, etc
