Long Run AS & AD Model Essentials

Transcription

1 Macro Long Run A & Model Essentials The short run A & model looks at a orld in hich input prices ere fixed. It s a useful model for analyzing hat the immediate effects of government policy change or realorld event might be on inflation, output/income, and unemployment. That said, its usefulness is limited because it doesn t tell us ho e are doing at a point in time, nor does it tell us hat occurs hen e do allo input prices to change. For this, e ill need the long run model. The hort Run A & Model The short run is a period of time during hich resource prices are fixed The intersection of and give us short run equilibrium The question e need to ask is, Is everything great at R equilibrium? hort run equilibrium is not very informative R equilibrium merely says that =. It doesn t tell us hether the R equilibrium level of output is high or lo. We need a benchmark against hich e can judge the performance of the economy. Potential GP Achieving productive efficiency requires us to fully use our resources, including labor. In order to be on the PPF e have to be at full employment. We have to achieve potential GP (PGP). Add PGP to the graph using the symbol P. This ill be our benchmark. ort Run = E P Economy experiencing a recessionary gap

2 Recessionary Gaps In the graph above, E is much less than P. Our current output is much loer than it could be. ince P requires full employment, the fact that E is less than P also means you have high unemployment on your hands When e suffer from periods of lo output and high unemployment, e refer to those periods as recessions. o, henever E < P, you have a recessionary gap. ort Run = P E Economy experiencing an inflationary gap Inflationary Gaps In the graph above, E is larger than P. Our current output is higher than the maximum sustainable level of output. ince P requires full employment, the fact that E is higher than P also means you have abnormally lo unemployment on your hands o, henever E P, you have an inflationary gap. What does adding P gain us? Adding P to the model allos us to gauge the current performance of the economy. If E = P e are at potential GP and are achieving full employment. If E P, e have a recessionary gap on our hands. We have lo output and high unemployment. If E P, e have an inflationary gap on our hands. We have very high output and abnormally lo unemployment.

3 Connecting the labor market to the A & model full employment If E = P e are achieving potential GP. This means e are at full employment. If e look at the labor market, this means that our current age must be the equilibrium age,. ince e are at equilibrium in the labor market, there is no pressure on the age rate to change, and therefore no pressure on the curve to shift. E = P = Labor Market Connecting the labor market to the A & model recessionary gap If E P e have a recessionary gap and high unemployment. Therefore, if e look at the labor market, this means that our current age must be above the equilibrium age,. ince e have a surplus in the labor market (unemployment) there is pressure on ages to fall. As ages fall, the should shift out. (Input prices are the first shifter of.) 2 C 2 E E2 = P E high unemployment

4 Connecting the labor market to the A & model inflationary gap If E P e have an inflationary gap and abnormally lo unemployment. Therefore, if e look at the labor market, this means that our current age must be belo the equilibrium age,. ince e effectively have a shortage in the labor market there is significant upard pressure on ages. As ages rise, the should shift back. (Again, input prices are the first shifter of.) 2 2 C E2 = P E E abnormally lo unemployment The elf Correcting Mechanism As long as the age rate is free to move, it should adjust to get rid of any surplus or shortage in the labor market. The changing age rate, in turn, shifts the until e reach P. This is the economy s self correcting mechanism. Long Run Aggregate upply If the self correcting mechanism orks, then eventually e alays end up reaching P. If firms alays supply P in the long run, e might as ell dra in a ne vertical A curve there and call it the long run aggregate supply () curve. The point at hich = is called long run equilibrium.

5 Long Run Long Run E = P An economy at full employment hort Run vs. Long Run hort Run equilibrium is pretty uninformative. es, the supply of goods and services equals the demand for goods and services in short run equilibrium. Hoever, that supply could be quite lo or abnormally high. We could have a recessionary gap of an inflationary gap on our hands. If e are in long run equilibrium though, e are achieving potential GP and are at full employment. Long Run 2 hort Run 2 Long Run hort Run E P P E An economy closing a recessionary gap An economy closing an inflationary gap