ECON 203 Chapter 9-13 Introduction to Macroeconomics
study guide exam update (Concordia University)
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CHAPTER 9
FROM THE SHORT RUN TO THE LONG RUN: THE
ADJUSTMENT OF FACTOR PRICES
9.1 THREE MACROECONOMIC STATES
In the last three chapters, we considered the economy in the short run. In the next
chapter we will examine the economy in the long run. In this chapter we explore the
details of the crucial adjustment process that takes the economy from its short-run
equilibrium to its long-run state.
*REMINDER*
An economy’s level of potential GDP is the amount of output that can be produced
when all land, labour, and capital are fully employed. In the short run, real GDP may be
above or below as a result of various aggregate demand or aggregate supply shocks.
The Short Run The Adjustment The Long Run
Process
Key
Assumptions Factor prices Factor prices are Factor prices are
areexogenous. flexible/endogenou fully
s adjusted/endogenou
Technology and . s
factor supplies (and .
thus Y*) are Technology and
constant/exogenous. factor supplies (and Technology and
thus Y*) are factor supplies
constant/exogenou (andthus Y*) are
s. changing.
What Happens Real GDP (Y) is Factor prices Potential (Y*) GDP
determined by adjustto output usually growsover
aggregate gaps; realGDP the long run.
demandand eventually returns
aggregate to Y*.
supply.
Why We Study To show the effects To see how output To understand
This State of AD and AS shock gaps cause factor the nature of
s on real GDP. prices to change long-run
and economic
why real GDP tends growth.
to return to Y*.
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9.2 THE ADJUSTMENT PROCESS
I. POTENTIAL OUTPUT AND THE OUTPUT GAP
*REMINDER*
Potential output is the total output that can be produced when all productive
resources— land, labour, and capital—are fully employed. When a nation’s actual
output diverges from its potential output, the difference is called the output gap.
Figure 9-1 – Output Gaps in the Short Run
The output gap is the difference between actual GDP and potential GDP, Y – Y*.
Potential output is shown by the vertical line at Y*. 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.
II. FACTOR PRICES AND THE OUTPUT GAP
We make two key assumptions in our macro model regarding factor prices and the
outputgap:
• First, when real GDP is above potential output, there will be pressure on
factorprices 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
factorprices to fall because of a lower-than-normal demand for factor inputs.
Output Above Potential, Y > Y*
The boom that is associated with an inflationary gap generates an excess demand
forfactors that tends to cause wages (and other factor prices) to rise.
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Output Below Potential, Y < Y*
The slump that is associated with a recessionary gap generates an excess supply of
factorsthat tends to cause wages (and other factor prices) to fall.
Downward Wage Stickiness
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.
Inflationary and Recessionary Gaps
Now it should be clear why the output gaps are named as they are. 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 Y > Y*.
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 Y < Y*.
III. POTENTIAL OUTPUT AS AN “ANCHOR”
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.
9.3 AGGREGATE DEMAND AND SUPPLY SHOCKS
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