from Short-Run to Long-Run
Adjustment of Factor Prices
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 The general idea of short-run vs long-run in Economics
 Short-run: at least one variable is fixed
 Factory size
 Long-run: all the variables are adjustable
 Some variables get “endogenized” in long run model
compared to a short-run model
 There’s a continuum and we simplify it to focus on
important features
 The model we have worked through was short-run
 Factor prices are exogenous
 Technology and factor quantities are constant
 The long-run:
 Factor prices fully adjust
 Technology and factor quantities are changing
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 The model we worked on today is in-between
 Factor prices adjust
 Technology and factor quantities are constant
 Always keep in mind we are talking models
here
 Short-run: analysis of actual Y fluctuating around
potential (full-employment) Y*
 Long-run: analysis of economic growth
 In-between: analysis of adjustments
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 Graphically,
 Inflationary gap:
 Either (I) expansionary AD shock, or (II) positive AS
shock
 AS-AD
 Potential output
 Factor prices adjustment
 GDP trajectory
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 Recessionary gap:
 Either (I) contractionary AD shock, or (II) negative AS
shock
 AS-AD
 Potential output
 Factor prices adjustment
 GDP trajectory
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 Sticky wages and speed of adjustment:
 Recessionary gap - slower
 Inflationary gap – faster
 Inflation and adjustment of real wages
 The Phillips curve
 The rate of change of wages vs unemployment
rate
 Inflation rate vs unemployment rate
 We can think of potential Y* as an anchor and
actual Y fluctuating around Y*
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 Sticky wages and speed of adjustment:
 Recessionary gap - slower
 Inflationary gap – faster
 Inflation and adjustment of real wages
 The Phillips curve
 The rate of change of wages vs unemployment
rate
 Inflation rate vs unemployment rate
 Long-run equilibrium
 Potential Y* and comparative statics without AS
 Changes in potential Y*
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 Fiscal stabilization policy again
 Recessionary gap
 Increasing G
 Reducing t
 Time lag
 Decision lag
 Execution lag
 The time lag, “natural” recovery, and destabilization
 Inflationary gap
 Decreasing G
 Increasing t
 The time lag, “natural” recovery, and destabilization
 Fiscal policy and duration of a business cycle
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 The paradox of thrift
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We want to save if the times turn tough
If everybody saves, C (and G?) fall
The equilibrium Y falls
And the times get even tougher
Keynes insisted we “spend our way” our of Great
Depression
 The paradox of thrift is a short-run phenomenon!
 Automatic fiscal stabilizers
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Recall, T = tY
As Y declines, tY declines
YD increases
Think of M = 1/(1-z), where z = MPC(1-t)-m
 Simple multiplier with government
 Simple multiplier without government
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 Practical fiscal policy
 Time lags
 Fiscal policy is appropriate for prolonged, not short,
recession
 Tax changes
 Temporary tax change and forward-looking population
 Permanent tax change and G in long run
 Laffer curve
 Good attitude
 Fine tuning is bad
 Gross tuning may be good
 G and Y*
 Crowding out and investments through G
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