Transcript Modern MacroEconomics: From Short Run to Long Run

C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
Copyright © 2012 Pearson
Prentice
Hall.
All rights
reserved.
Copyright
© 2012
Pearson
Prentice
Hall. All rights reserved.
15-1
CHAPTER
Modern Macroeconomics:
From the Short Run to the Long Run
15
Just prior to the start of the December 2007 recession, unemployment stood at
4.7 percent. It rose to over 10 percent in 2009.
PREPARED BY
Brock Williams
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
APPLYING THE CONCEPTS
1
What steps can policymakers take to deal with a possible
liquidity trap?
Avoiding a Liquidity Trap
2
What are the links between presidential elections and
macroeconomic performance?
Elections, Political Parties, and Voter Expectations
3
Will increases in health-care expenditures crowd out
consumption or investment spending?
Increasing Health-Care Expenditures and Crowding Out
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15-3
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.1
LINKING THE SHORT RUN AND THE
LONG RUN
The Difference between the Short and Long Run
●short run in macroeconomics
The period of time in which prices do not
change or do not change very much.
●long run in macroeconomics
The period of time in which prices have
fully adjusted to any economic changes.
Should economic policy be guided by what we expect to happen in the short
run, as Keynes thought, or what we expect to happen in the long run, as
Friedman thought? To answer this question, we need to know two things:
1 How does what happens in the short run determine what happens in the
long run?
2 How long is the short run?
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15-4
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.1
LINKING THE SHORT RUN AND THE
LONG RUN (cont’d)
Wages and Prices and Their Adjustment over Time
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not its “face” value.
●wage–price spiral
The process by which changes in wages
and prices cause further changes in
wages and prices.
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15-5
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT
Using aggregate demand and aggregate supply, we can illustrate graphically how
changing prices and wages help move the economy from the short to the long run.
1 Aggregate demand.
●aggregate demand curve
A curve that shows the relationship between the level of prices and the
quantity of real GDP demanded.
2 Aggregate supply.
●short-run aggregate supply curve
A relatively flat aggregate supply curve that represents the idea that prices
do not change very much in the short run and that firms adjust production to
meet demand.
●long-run aggregate supply curve
A vertical aggregate supply curve that reflects the idea that in the long run,
output is determined solely by the factors of production and technology.
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15-6
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (cont’d)
Returning to Full Employment from a Recession
 FIGURE 15.1
How the Economy Recovers from a Downturn
If the economy is operating below full employment, as shown in Panel A, prices will fall, shifting
down the short-run aggregate supply curve, as shown in Panel B.
This will return output to its full-employment level.
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15-7
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (cont’d)
Returning to Full Employment from a Boom
 FIGURE 15.2
How the Economy Returns from a Boom
If the economy is operating above full employment, as shown in Panel A, prices will rise, shifting the
short-run aggregate supply curve upward, as shown in Panel B.
This will return output to its full-employment level.
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15-8
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (cont’d)
Returning to Full Employment from a Boom
In summary:
• If output is less than full employment, prices will fall
as the economy returns to full employment.
• If output exceeds full employment, prices will rise
and output will fall back to full employment.
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15-9
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (cont’d)
Economic Policy and the Speed of Adjustment
FIGURE 15.3
Using Economic Policy to
Fight a Recession
Rather than letting the
economy naturally return to full
employment at point b,
economic policies could be
implemented to increase
aggregate demand from AD0 to
AD1 to bring the economy to
full employment at point c.
The price level within the
economy, however, would be
higher.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
15-10
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
APPLICATION
1
AVOIDING A LIQUIDITY TRAP
APPLYING THE CONCEPTS #1: What steps can
policymakers take to deal with a possible liquidity trap?
•Fed Chairman Ben Bernanke became concerned when the federal funds rate fell below
0.5 percent in 2008. What could be done to avoid a liquidity trap?
•One way was to commit to higher inflation in the future. Although nominal interest rates
cannot go below zero, real interest rates could. However, the Fed is responsible for
maintaining low interest rates, so this is not an ideal policy.
•Instead, the Fed began paying interest rates on bank reserves. Since banks could
earn a minimum interest rate with deposits, this effectively put a floor on interest rates.
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15-11
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.2
HOW WAGE AND PRICE CHANGES MOVE
THE ECONOMY NATURALLY BACK TO FULL
EMPLOYMENT (cont’d)
Liquidity Traps
●liquidity trap
A situation in which nominal interest
rates are so low, they can no longer fall.
Political Business Cycles
●political business cycle
The effects on the economy of using
monetary or fiscal policy to stimulate the
economy before an election to improve
reelection prospects.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
15-12
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
APPLICATION
2
ELECTIONS, POLITICAL PARTIES, AND VOTER EXPECTATIONS
APPLYING THE CONCEPTS #2: What are the links between
presidential elections and macroeconomic performance?
The original political business cycle theories focused on incumbent presidents trying to
manipulate the economy in their favor to gain reelection. Subsequent research began to
incorporate other, more realistic factors.
• The first innovation was to recognize that political parties could have different goals or
preferences.
• Republicans historically have been more concerned about fighting inflation,
whereas Democrats have placed more weight on reducing unemployment.
• The second major innovation was to recognize that the public would anticipate that
politicians will try to manipulate the economy.
• If the public is not sure who will win the election, the outcome will be a
surprise to them—a contractionary surprise if Republicans win and an
expansionary surprise if Democrats win.
• This suggests that economic growth should be less if Republicans win and
greater if Democrats win. The postwar U.S. evidence is generally supportive of this
theory
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15-13
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not its “face” value.
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15-14
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS
 FIGURE 15.4
How the Changing Price Level Restores the Economy to Full Employment
With the economy initially below full employment, the price level falls, as shown in Panel A, stimulating
output.
In Panel B, the lower price level decreases the demand for money and leads to lower interest rates at
point d.
In Panel C, lower interest rates lead to higher investment spending at point f.
As the economy moves down the aggregate demand curve from point a toward full employment at point
b in Panel A, investment spending increases along the aggregate demand curve.
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Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS (cont’d)
Why changes in wages and prices restore the economy to full
employment:
(1) Changes in wages and prices change the demand for money.
(2) This changes interest rates, which then affect aggregate
demand for goods and services and ultimately GDP.
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15-16
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS (cont’d)
The Long-Run Neutrality of Money
 FIGURE 15.5
Monetary Policy in the Short
Run and the Long Run
As the Fed increases the
supply of money, the
aggregate demand curve
shifts from AD0 to AD1 and the
economy moves to point a.
In the long run, the economy
moves to point b.
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15-17
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS (cont’d)
The Long-Run Neutrality of Money
 FIGURE 15.6
The Neutrality of Money
Starting at full employment, an increase in the supply of money from Ms0 to Ms1 will initially reduce
interest rates from rF to r0 (from point a to point b) and raise investment spending from IF to I0 (point c to
point d). We show these changes with the red arrows.
The blue arrows show that as the price level increases, the demand for money increases, restoring
interest rates and investment to their prior levels—rF and IF, respectively. Both money supplied and
money demanded will remain at a higher level, though, at point e.
15-18
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS (cont’d)
The Long-Run Neutrality of Money
●long-run neutrality of money
A change in the supply of money
has no effect on real interest rates,
investment, or output in the long
run.
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15-19
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.3
UNDERSTANDING THE ECONOMICS OF
THE ADJUSTMENT PROCESS (cont’d)
Crowding Out in the Long Run
 FIGURE 15.7
Crowding Out in the Long Run
Starting at full employment, an increase in government spending raises output above full employment. As
wages and prices increase, the demand for money increases, as shown in Panel A, raising interest rates
from r0 to r1 (point a to point b) and reducing investment from I0 to I1 (point c to point d ).
The economy returns to full employment, but at a higher level of interest rates and a lower level of
investment spending.
15-20
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
APPLICATION
3
INCREASING HEALTH-CARE EXPENDITURES AND CROWDING OUT
APPLYING THE CONCEPTS #3: Will increases in health-care
expenditures crowd out consumption or investment spending?
•In 1950, health-care expenditures in the United States were 5.2 percent of GDP;
by 2000, this share had risen to 15.4 percent.
•Since 1950, the average life span has increased by 1.7 years per decade.
•Two economists, Charles I. Jones and Robert E. Hall, go further and suggest
normal increases in economic growth will propel health-care expenditures to
approximately 30 percent of GDP by mid-century.
•Their argument is that as societies grow wealthier, individuals face the tradeoff of
buying more goods (automobiles or cars) to enjoy their current life span or spending
more on health care to extend their lives.
•Assuming this argument is correct and health-care expenditures increase, what
other component of GDP will fall?
• If investment is crowded out, living standards would fall in the long run, reducing
the ability to consume both health and non-health goods.
• Spending on health would then come at the expense of spending on consumer
durables or larger houses. That would be the preferred outcome.
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15-21
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
15.4
CLASSICAL ECONOMICS IN
HISTORICAL PERSPECTIVE
Say’s Law
Classical economics is often associated with Say’s law, the doctrine
that “supply creates its own demand.”
Keynes argued that there could be situations in which total demand fell
short of total production in the economy for extended periods of time.
Keynesian and Classical Debates
If wages and prices are not fully flexible, then Keynes’s view that
demand could fall short of production is more likely to hold true.
However, over longer periods of time, wages and prices do adjust
and the insights of the classical model are restored.
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15-22
C H A P T E R 15
Modern Macroeconomics:
From the Short Run to the
Long Run
KEY TERMS
aggregate demand curve
liquidity trap
long-run aggregate supply curve
long run in macroeconomics
long-run neutrality of money
political business cycle
short-run aggregate supply curve
short run in macroeconomics
wage–price spiral
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15-23