Transcript NATIONAL INCOME & THE PRICE LEVEL IN THE LONG RUN

NATIONAL INCOME & THE PRICE
LEVEL IN THE LONG RUN
Chapter 32 - Lipsey
POTENTIAL INCOME AND THE GDP GAP
• Potential income is represented by a vertical
line Y*. (Fig. 32.1)
• Output gap = horizontal distance between Y*
and Y (as determined by the intersection of AD
and SRAS)
Recessionary Gap
Inflationary Gap
FACTOR PRICES & THE OUTPUT GAP
• Upward and downward wage pressures
• Actual GDP exceeds potential GDP
• Potential GDP exceeds actual GDP
• Adjustment asymmetry
THE LONG-RUN CONSEQUENCES
OF AGGREGATE DEMAND SHOCKS
EXPANSIONARY SHOCKS
Rise in AD creates inflationary gap.
Causes wages to rise faster than
productivity.
Unit cost rise – SRAS shifts to the left
– prices rise.
Output falls back to potential level.
DEMAND SHOCK INFLATION (Fig 32.2)
Autonomous increase in aggregate demand
Induced shift in aggregate supply
THE LONG-RUN CONSEQUENCES
OF AGGREGATE DEMAND SHOCKS
CONTRACTIONARY SHOCKS
These shocks work in
opposite direction
creating a recessionary
gap
Factor prices tend to be
sticky, the automatic
adjustment process tends
to be slow and gap
persists
(FIG 32.3) – DEMAND SHOCK
DEFLATION WITH FLEXIBLE WAGES
Autonomous Falls In Aggregate Demand
Induced Shift In Aggregate Supply
LONG RUN AGGREGATE SUPPLY CURVE
(SRAS)
FIG: 32.4
Relates the price level
and national income
after all costs wages
and other costs have
been adjusted fully to
long-run equilibrium
LONG-RUN EQUILIBRIUM AND
AGGREGATE SUPPLY (Fig. 32.5)
When LRAS is vertical, aggregate supply determines Y*.
Given Y*, aggregate demand determines equilibrium P.
NATIONAL INCOME IN THE SHORT &
LONG RUN
Three ways of increasing national income – Fig 32.6
An increase in AD
A temporary increase
in aggregate supply
Permanent increases
in aggregate supply
CYCLICAL FLUCTUATIONS
• Demand shocks are an important source of
business cycles
• As a result of shocks and the adjustment
mechanism, GDP often exhibits a cyclical
pattern
• In the long run ( i.e. GDP = Y*) the higher the
level of national savings the higher the level
of asset formation will be.
• Assets formed in the current period will yield
increases in the national income in the
future.
FISCAL POLICY AND THE
BUSINESS CYCLE
• Fiscal policy can be used to stabilize the
position of the AD curve at or near potential
GDP.
• To remove a recessionary gap, governments
can shift AD to the right by cutting taxes and
increasing spending
• To remove an inflationary gap, governments
can pursue the opposite policies
THE BASIC THEORY OF FISCAL
STABILIZATION
REMOVAL OF A RECESSIONARY GAP – Fig 32.8
(1) Rightward shift in SRAS
(2) Rightward shift in AD
THE BASIC THEORY OF FISCAL
STABILIZATION
REMOVAL OF A INFLATIONARY GAP – Fig 32.9
(1) Leftward shift in SRAS
(2) Leftward shift in AD
THE PARADOX OF THRIFT
Paradox of thrift - When the economy is in a
recessionary gap, increases in desired savings on
the part of firms, persons, and governments are
likely to lead to further reductions in GDP and
may lead to reductions in actual saving.
 In the long run, with the economy at Y* the
paradox does not obtain, and increased thrift will
lead to increased asset accumulation and
economic growth
AUTOMATIC STABILIZERS
• Government tax and transfer programs tend
to reduce the size of the multiplier, they act as
automatic stabilizers.
• When national income changes, in either
direction, disposable income changes by less
because of taxes and transfers.
LIMITATIONS OF DISCRETIONARY
FISCAL POLICY
• Discretionary fiscal policy is subject to decision
lags and execution lags that limit its ability to
take effect quickly.
• Some economists argue that these limitations
are so severe that fiscal policy should never be
used for stabilization because it will do more
harm than good.
• Others argue that the automatic adjustment
mechanism works so slowly that fiscal policy can
play an important role in stabilizing the economy.
ECONOMIC POLICY, ECONOMIC STABILITY AND
ECONOMIC GROWTH
Fiscal policy has very
different effects in the
short and long run.
The same fiscal policy (i.e.
tax & govt. expenditure)
that
stimulate
the
economy in the short run
will, if pursued at full
employment , reduce
national savings, asset
formation and economic
growth in the long run.
Fig. 32.10 – Effects of Fiscal
policies that are not reversed