Chapter 9 - The Adjustment of Factor Prices

Question 1

What are the three Macroeconomic states?

Answer 1

1) Short run
2) Adjustment process
3) Long run

Question 2

What are the key assumptions of each of the three models?

Answer 2

1) Short run:
- Factor prices are assumed to be exogenous, they may change but not explained in the model.
- Technology and factor supplies are assumed to be constant so Y* (Potential output/gdp) is constant.
- Real GDP is determined by AS and AD (Aggregate supply/demand curves)

2) Adjustment process:
- Factor prices are assumed to adjust (flexible/endogenous) in response to the output gaps (inflationary or recessionary).
- Technology and factor supplies are assumed to be constant.
- GDP eventually goes back to Y*

3) Long Run:
- Factor prices are fully adjusted to any output gap.
- Technology and factor supplies are assumed to be constant.
- Potential GDP (Y*) grows over the long run.

Question 3

What is an output gap? When does it happen?

Answer 3

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

The inflationary gap when Y>Y* (output is above potential)

Recessionary gap when Y*>Y (Output is below potential)

Question 4

Why do we study each of the three states?

Answer 4

1) Short run: To show the effects of AD and AS shocks on real GDP.

2) Adjustment process: To see how output gaps cause factor prices to change and why real GDP tends to return to Y*.

3) Long Run: To understand the nature of long-run economic growth.

Question 5

Explain the causes/requirements of an inflationary gap; Y>Y* (output is above potential)

Answer 5

• Excess demand for input because firms are producing beyond their normal capacity.
• Workers have bargaining power because they are in demand, which puts upwards pressure so their salary tends to increase.

Question 6

Explain the causes/requirements of an inflationary gap; Y*>Y (output is below potential)

Answer 6

• Firms are producing below their normal capacity, and there is an excess supply of input (including workers)
• Firms will have below-normal sales and profits, and may seek a reduction in salaries.

Question 7

Explain the concept of downward wage stickiness.

Answer 7

Different speeds of wage/salary adjustments. Booms cause wages to rise rapidly. Recessions cause wages to fall slowly.

Question 8

What does the Phillips curve represent?

Answer 8

Phillips curve represents a negative relationship between unemployment and the rate of change in wages.
Wages tend to fall in periods of high unemployment and rise in periods of low unemployment.

Question 9

What serves as an anchor, following a AD or AS shock?

Answer 9

The potential output (Y) serves as an anchor because we assume that prices will adjust to eventually reach equilibrium at potential output Y.

Alternate answer: Following any AD or AS shocks, the adjustment of factor prices continues until real GDP returns to Y*

Question 10

How do we know when the economy is in long-run equilibrium?

Answer 10

The economy is in long-run equilibrium when the adjustment process is complete and there is no longer any output gap. So the economy is in long-run equilibrium when the intersection of the AD and AS curves occurs at Y*.

Question 11

How do we calculate the marginal propensity to spend on the national income level (z) and the simple multiplier?

Answer 11

With no government and no taxes, z is the marginal propensity to consume/spend.
With govt and taxes z gets smaller and is given by:

z = MPC (1-t) - m

Simple multiplier = 1/(1-z)

So the lower the tax rate (t), the large the simple multiplier and therefore real GDP acts less stable after shocks.