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Economics HL Notes Lipsey Ch. 26
Output and Prices in the Long Run
Lipsey Chapter 26
A genda

Introduction

Output Gaps and the Adjustment Process

Long Run Aggregate Supply

Fiscal Stabilization Policy

Long Term Economic Growth
I. Introduction
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Short Run vs. Long Run
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The Short Run Aggregate Supply (SRAS) was drawn under these assumptions:
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___________ factor prices (wages, oil price, etc.)
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___________ technology
Long Run Aggregate Supply (LRAS):
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Factor prices are ___________
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Factor prices ___________ according to economic conditions
So what happens to Long Run Equilibrium national income and price level?
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For example, if Government keeps increasing G, can real GDP keep increasing?
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If so, we live happily forever ...
If not, why not?
II. Output Gaps and the Adjustment Process
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Potential output
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Definition
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the level of national output when all factors of production are employed at normal rates of
capacity utilization
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
We will use Y* to denote the potential output
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Note
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Y* is determined by past economic growth and current technology
Y* does not vary with the price level
Output Gaps
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Economics HL Notes Lipsey Ch. 26
When actual output (Y) differs from potential output, OUTPUT GAP
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Output Gap = Y – Y*
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Inflationary Gap:
Y-Y* >0
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Recessionary Gap:
Y-Y* <0
The reason why continued government spending cannot bring about continued and
sustainable growth is related to the ____________________________________________ which
occurs when there is an output gap
The Adjustment Process (I) – from Inflationary Gap (Draw Graph on right)
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Suppose that the economy is at initial SR
equilibrium (Y*, PL0)
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
Then suppose that the government decides
to increase G at all levels of national output
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Y* is the level of potential output
AD0 and SRAS0 are the initial AD and
SRAS curves
AD shifts to the right from AD0 to AD1
The new short run equilibrium is (Y1,
PL1)
Since Y1 > Y*, there is an inflationary
output gap
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The economy is working above normal
rates of capacity utilization
There is increased demand for labor
and other factors of production
Monetary wages and other factor
prices increase faster than
productivity
______________________ increases
SRAS shifts to the left (upwards)
SRAS continues to shift leftwards until
output goes back to Y*, or SRAS1
The new equilibrium is (Y*, PL2)
i.e. the economy has ADJUSTED back
to the potential output Y*
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
The Adjustment Process (II) – from Recessionary Gap (Draw graph on right)

Suppose that the economy is at initial SR
equilibrium (Y*, PL0)
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
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Y* is the level of potential output
AD0 and SRAS0 are the initial AD and
SRAS curves
Then suppose that there is negative
shock to aggregate demand
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Could be from autonomous C, I, G or
NX
AD shifts to the left from AD0 to AD1
The new short run equilibrium is (Y1,
PL1)
Since Y1 < Y*, there is a recessionary
output gap
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
Economics HL Notes Lipsey Ch. 26
The economy is working below
normal rates of capacity utilization
There is decreased demand for labor
and other factors of production
Monetary wages and other
factor prices decrease faster
than productivity
____________ __________
decreases
SRAS shifts to the right (downwards)
SRAS continues to shift rightwards
until output goes back to Y*, or
SRAS1
The new equilibrium is (Y*, PL2)
i.e. the economy has ADJUSTED
back to the potential output Y*
Key features of the Adjustment Process
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_______________ _______
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The economy adjusts itself back to the potential output level, if actual Y differs from Y*
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Key is _________________________________
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If input prices are not flexible, SRAS does not shift
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Price Level ______________________
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If start with inflationary gap, then adjustment process involves further inflation
PL changes first from PL0 to PL1 then from PL1 to PL2
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If start with recessionary gap, then further deflation

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Real output stays at the ______________________ output level in the long run
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Changes in output due to changes in AD can only be temporary
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But composition of the outputs differ from before and after
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Economics HL Notes Lipsey Ch. 26

For example, in the expansionary fiscal policy case,

From (Y*, PL0) to (Y*, PL2), G has increased
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But C and NX have decreased
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The increase in government expenditure has entirely “crowded out” C and NX – the
‘crowding-out’ effect of expansionary fiscal policy
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The adjustment process ______________________
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Time is needed to change production capacity
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Time is needed to hire (or fire) workers
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The multiplier process takes time
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Wages could be fixed during the year due to union wage contracts and therefore changes in
unit costs also take time
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As a result of the all the above factors, there is usually a lag of months or even a year to the
adjustment process

Adjustment ______________________
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Booms cause unit costs to rise rapidly – SRAS shifts to the left fast
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Recessions cause unit costs to fall only slowly - SRAS shifts to the right slowly
 Wages stickiness
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The adjustment process works ___________ for booms, but ___________ for recessions
 The economy may be stuck in the recessionary gap for a lon g time
III. Long Run Aggregate Supply (LRAS)

The LRAS describes the relationship between national output and price level when
_________________________________changes are accounted for

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The LRAS is a vertical line at Y* and is
not variable with the price level
The vertical LRAS is “Classical” LRAS as
Classical economists focused on the long
run.

The LRAS is ____________________
as the vertical portion of the SRAS.


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The output level at the vertical
portion of the SRAS is Ymax,
which is the maximum output the
economy can produce, for
example in an all out war effort

All factors of production are
employed at ___________
rates of utilization

The economy is not able to
produce more than Ymax
In comparison, the LRAS is fixed
at Y*, the potential output

All factors of production are
employed at ___________
rates of utilization
Hence Ymax > Y* generally
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

Economics HL Notes Lipsey Ch. 26
Lipsey’s perspective is classical
Keynesian LRAS?
IV. Fiscal Stabilization Policy
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If an economy is in recessionary gap (due to negative shock) (Draw graph below)
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Natural adjustment process can close the recessionary gap
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But may work ______________________ (due to sticky factor prices)
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Unemployment and recession may be persistent
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Then there is a need for ______________________
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Fiscal stabilization policy can close the recessionary gap
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Increases G
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AD shifts to the ______________________
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Recessionary gap is closed
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
If an economy is in inflationary gap (due to positive shock) (Draw graph below)
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Natural adjustment process can close the inflationary gap
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But ______________________ occurs
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______________________ policy can also close the inflationary gap
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Decreases G
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AD shifts to the______________________
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Inflationary gap is closed
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No further inflation
Business cycles and the stabilization policy
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The economy is subject to constant shocks (either AD or AS) and goes through business cycles
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Government stabilization policy may be needed
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But, potential problems with government intervention
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Economics HL Notes Lipsey Ch. 26
____________ __________
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To change G and T takes due political process – can be lengthy
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Decision lag
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Execution lag
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Multiplier effect also takes time
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By the time effect takes place, business cycle may have reversed
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Fiscal policy may end up being destabilizing!
____________ __________
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How much to change G and T?
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Simple multiplier size (or marginal propensity to withdraw)
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Slope of SRAS curve
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Should the government do
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’fine-runing’?
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’gross-tuning’?
___________ or ___________ policy changes?
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Tax policies tend to be permanent
Balanced Budged Revisited – effect on business cycles
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In a boom, Y increases
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T increases (T = net tax revenue = t x Y)
To balance the budget, must increase G
AD shifts to the right
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
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it moves with the business cycle
Balanced Budget does NOT stabilize the economy
The unbalanced budget is an automatic stabilizer
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Automatic Stabilizer
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Anything that automatically stabilizes the economy even if the government does not do anything
discretionary
Unbalanced budget
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
T decreases
To balance the budget, must decrease G
AD shifts to the left
Y decreases even further
Balanced budget makes the recession ___________
In conclusion, Balanced Budget is “___________”


Y increases even further
Balanced budget makes the boom ___________
In a recession, Y decreases
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
Economics HL Notes Lipsey Ch. 26
Suppose we are in a recession (Y decrease),
 T decreases
 Yd = Y - T decreases, but by less than without T
 C decreases by less than without T
 AE decreases by less than without T
 The budget (or the public saving function) automatically ___________ the recession
Suppose we are in an inflationary gap
 The public saving function automatically ___________ th e in flationary effect
It acts as an ______________________r
Paradox of Thrift

Intuition might tell us if the country is in a recession, i.e. our income decreases, we should “tighten
our belts” to go through the difficult period
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After all, a recession means we have less money to buy things and therefore we should
decrease consumption and save more

This intuition comes from our own personal experience
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If your family income has decreased,
 your family should tighten its belt and try to go through the hard time
 However, what is right for an individu al fam ily is not necessarily right for th e entire country

In the Short Run, if we save more (S increases)
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we are spending less (C decreases)
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thus AD shifts ______________________
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Y _________________________________
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So “thrift” does not help us out of a recession
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This is called the “______________________”
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Economics HL Notes Lipsey Ch. 26
V. Long Term Economic Growth

Governments can___________ use increased spending to bring about long term economic growth
(Draw graph below)
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

LR equilibrium is at Y*
Expansionary fiscal policy only causes______________________ in the long run!
In fact, the only way for the economy to grow in the long run is through the ___________ shifting
to the right
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Increases in AD brings about only ___________ changes to real GDP

Increases in AS must be ___________ to bring about permanent changes in real GDP – through
shifts of ___________
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