Wednesday, February 17, 2010


It is generally believed that labour accounts for about 2/3 of all income generated, and that capital accounts for approximately 1/3 of national income

as such, percentage-growth in potential national income is = to the percentage change in the level of technology + 2/3 * the percentage change in labour + 1/3 * the percentage change in capital


-It is impossible to directly measure technological change. Solow tried, and got a Nobel Prize.

-The Solow growth model included only 3 independent varaibles: labour, capital, and "other"

-This "other" is the "Solow Residual" or "Total Factor Productivity" or "A" (in our model). It captures all growth in GDP which is not accounted for by changed in N (L and H) and K.

-BIG PROBLEM HERE: Solow's model included both the quantity and quality of labour and capital, and a great deal of technological change is EMBODIED with labour or capital (so technology factors into labour or capital, and cannot always be separated them from). For instance, if one of my shitty sweat-shop sewing machines breaks down and I decide to replace it with an uber-fast, ultra-modern sewing machine, the capital stock will remain the same for my sweatshop, but the technology level has increased.

-As such, the Solow residual underestimates true technical change (as it can only include disembodied technological changes)


The Cobb-Douglas Aggregate Production Function is an example of an aggregate production function with 2 characteristics
-The law of diminishing marginal utility
-Constant returns to scale

For this APF, Y = A * N(2/3) * K(1/3)

Here, equal growth rates in labour and capital cause total GDP to grow at the same rate (as it would in a steady state)

y = A * k(1/3)

This is the per-capita APF, where y is per-capita GDP, and k is the capital-labour ratio
Equal growth rates in both labour and capital (ie: a constant k) cause y (per capita GDP) to remain constant


1: Increase savings (let per capita savings become larger)- in order for growth to occur, the economy requires sufficient savings to increase the capital stock faster than the population growth.

If you are in the Robert Gateman club of not-breeding, choosing NOT to personally contribute to population growth can also help economies grow here...

2: Increase technology: This requires infrastructural developments (health, education, law, physiological needs such as food and water taken care of), and many such developments are difficult for developing nations to set up.


Technological improvements lead to increased productivity, which increases the potential per-capita GDP

Embodied Technical Change = technical change intrinsic to the particular human or unit of physical capital in use: it is a change in the quality of the input (so a higher education, or a computer upgrade would both be examples of embodied technical changes)

Disembodied Technical Change = technical change that is NOT intrinsic to human or physical capital in use. This is a change other than to the quality of the capital (so if my sweat-shop fore-woman comes up with a fantastic new sewing procedure which halves the time it takes her to sew a sneakers, and then she teaches all of her sweat-shop buddies how to sew like this, that new technique would be an example of a disembodied technical change)

Usually, disembodied changes eventually become embodied, so the distinction becomes less important over the long run.

CONVERGENCE HYPOTHESIS: This an interesting theory, and there are 2 different facets of it

1: Absolute Convergence: the tendency for GDP AND Growth Rates in GDP to be equal across nations: each nation will have the same steady state values for y* and k*
-This assumes that different countries have the same marginal propensity to save, the same rate of population growth, and the same rate of technological improvement
-This theory states that if two countries have the same growth model, then even if one starts farther to the left, they will both end up with the same standard of living

2: Conditional Convergence: the tendency for Growth Rates in GDP to be equal across nations: each nation will have the same steady state values.
-This theory assumes different marginal propensities to save for different nations, different population growth rates, and different technological growth rates
-This theory acknowledges that different countries will have different per-capita GDP, but states that they will have THE SAME GROWTH RATES!



The Neoclassical Growth Model made growth dependent on exogenous variables such as population growth, the savings rate, and the rate of technological change.

Some new growth theories alter the 2 assumptions of the Neoclassical Model:
-Instead of technology as exogenous, they state that technological changes can be explained within the economic model
-Instead of having diminishing marginal returns, some new growth models suggest that the marginal product of capital is constant, or that there is even increasing marginal product of capital over time!


Endogenous growth is self-sustaining growth
In this theory, we assume constant marginal product of capital
For an example, if the price of an input rises, firms will develop a new technology rather than just switching to an existing alternative input (so market structures and competition can facilitate technological change)
-Some people believe that competition foster technological change: others believe, especially in the case of health technologies, that only monopolies can risk the large expenditure required to create new drugs

LEARNING BY DOING: In the 1940s, Shumpeter said that innovation was a one-way street- that research caused new developments, which led to new machines and new products. Today, things work different: it is more of a 2-way street. There is a feedback mechanism (ie: the Japanese method of building cars, where the mechanics and workers collaborate with the designer in order to streamline research and production in such a way that is productively efficient).

-Different countries respond to economic shocks in different ways. Some will find different countries to produce goods in where costs are cheaper: others will change production methods and increase technology to make it more cost effective!


INCREASING MARGINAL RETURNS TO INVESTMENT: Here, each new addition to the capital stock is more productive than the last.

There are 2 sources of increasing marginal returns to investment:

Market-Development Fixed Costs (Paul Romer)
-The original investment into new knowledge or technology has a large fixed cost
-Adopting or adapting this new technology once it has already been established is cheaper
-Also, consumers, wait to use new technologies
-In this way, the costs decrease as more and more people adopt new technologies, so the returns to scale increase with increasing investment

-It is a public good, so it is not subject to the law of diminishing marginal returns
-New ideas are non-excludable and non-rivalrous (as much as copyright laws try to prevent people from accessing them)
-New ideas are pure public goods
-New ideas may not suffer diminishing marginal returns
-SOOOO, because ideas play such a big role in economics, and ideas are practically unlimited, economics doesn't have to the be DISMAL SCIENCE! Yay!



-1970s, the club of Rome published a book called "Limits to Growth"
-This book predicted that increased growth would eventually destroy the earth's resources...

Here is their usual anti-growth argument: growth will look like more of what we witness today: production of mostly useless, impractical consumer goods with a short lifespan, which end up in the landfills in a couple of years.

This could be countered with the argument that growth can still occur, but under that condition that instead of producer large quantities of shitty goods, we focus on producing higher-quality, cleaner, longer-lasting, more efficient products.
-Growth permits societies to protect the environment and help the poor (if you haven't noticed, environmental protection legislation is more a by-product of mature industrial economies, and less-so of developing nations)
-The thought is that market participants will react to supply shortages, and innovate around them (ie: by the time oil runs out, productive processes will have innovated away from it)

-Limits to growth are based on fixed technology and resources
-BUT, technology leads to more efficient resource use
-AND technology leads to the discovery of new resources
-Problem: THERE ARE TOO MANY PEOPLE: More people on the earth means that we will require more resource expenditure

-Economic growth creates pollution. Nuff said

Although many economists believe that growth creates opportunities for humankind to combat resource depletion and pollution through increased technologies, a lot of these beliefs are based on blind faith.

Like... we are basically relying on our ability to innovate away from these problems...

but what if we simply can't do that? Then what..............?

The Neoclassical Growth Model and Steady States

THE NEOCLASSICAL GROWTH THEORY: This focuses on capital accumulation, and how it is affected by savings

One important function in the neoclassical growth theory is the AGGREGATE PRODUCTION FUNCTION. This function shows the relationship between total real output and total inputs (sort of like a "macro" version of the production function for individual firms we saw in microeconomics)

REMEMBER from the last leccture? There are three main determinants of economic growth: labour, capital, and technology. Well, with the aggregate production function, we say that output is technology times a function of labour and capital

Y = A x F(N,K) where A = total factor productivity (disembodied technology), N = Labour and Human Capital, and K = capital (both quantity and quality)

Now what happens if we divide through by N?

Well, we get

y = A x F(k) where y is the amount of GDP produced per worker, and k is the amount of physical capital available for each worker

Also, potential output is also representable here

Y* = A x F(Nfe, Kfc) where Nfe is full employment, and Kfc is full capacity. In other words, potential output is technology times a function of labour at its full employment level, and physical capital at its full- capacity level

Some important things to remember:
We assume in the long run that income is at its potential level (that there is no output gap)
L is labour quantity, H is labour quality, and N includes both the quality and quantity of labour.
K includes both the quality and quantity of physical capital
We omit land as a factor input for the sake of simplicity in this model
Technology includes entrepreneurship and savviness


1: In the short run, there are diminishing returns to scale: as more of a variable factor is added to a given amount of fixed factor, the additional output generated by the added factor (the "return") will get increasingly smaller and smaller: they will diminish... ceteris paribus (they will diminish if all other things are held constant) after a certain point (they will not begin to diminish immediately)
But, this is only true of the short run when one factor is increased, and all other factors are held constant!

2: In the long run, there are constant returns to scale: When all factors increase the same amount, output will also increase by that amount (so if I double the amount of workers and also the amount of sewing machines, my sweat shop should double its output of shitty sneakers!)

3: Technology is nuetral: A affects the productivity of K and N equally, so although technology is present, it will not disproportionately impact any one factor.

Image Plz! y = f(k)

4: Steady state equilibrium: Here, the per-capita capital (k) and the per capita output (y) remain constant over time, so /\y = /\k = 0

If the population is growing at n, then income and capital must also grow at the same rate in order to remain in a steady state equilibrium. In other words, in order to be in a stead state equilibrium, the percentage change in output must equal the percentage change in capital, which must = the percentage change in the workforce.

y* and k* are the steady state values (they don't change over time)

Investment required to provide capital for new workers and to replace machines that have worn out (depreciation) is just equal to the national savings in a steady state equilibrium, so New Capital + Replacement Capital = Investment = Savings

If savings is greater than investment, than capital per worker will increase, and thus output per worker will also increase

If savings is just equal to investment, then the capital per worker will be k* and thus output per worker will be y*

When savings is equal to required investment, the economy is in a steady state equilibrium, each worker will have access to k*, and will produce y*


To maintain k at a constant rate, investment depends on both population growth and the depreciation rate. Some of investment will have to go to the new workers

WE ASSUME that the population growth rate is constant: thus, to keep capital per worker constant, you must grow capital by nk (the population growth rate times the amount of capital per worker)
WE ASSUME that the rate of depreciation is constant: thus to keep capital per worker constant, you must grow capital by dk as well (the depreciation rate times the amount of capital per worker)

The level of investment required to fund all of this capital growth to maintain a constant capital-worker ratio can be represented by
I = (n + d)k

Here, we assume that we have a frugal economy (there is no government or international trade)
We also assume that the marginal propensity to save is constant
S/N = sy = sf(k)
in other words, per capita savings are a function of per-capita output, which in turn, is a function of the labour-capital ratio

The net change in the capital-labour ratio is equal to the excess of actual savings over required investment
/\k = to per-capita savings - the capital-labour ratio multiplied by (the population growth rate + the rate of depreciation)

In a steady state, /\k = o, so per-capita savings must be equal to per-capita required investment
sy* = (n + d)k*

Image plz

If we graph the production function, the savings function, and the required investment function with money on the Y axis and the capital labour ratio on the X axis, the savings function and the required investment function will eventually intersect: this point is the steady state equilibrium, E
at E, actual investment is just equal to required investment
the capital-labour ratio k* and standard of living y* are constant
At capital labour ratios lower than k*, savings will be greater than required investment, so the capital labour ratio and the standard of living will both increase.

Economic Growth: Savings and Investments

The Very Long Run: Economic Growth Models

We can measure long run economic as the annual percentage change in per-capita real potential GDP.
Ecoonomic growth causes Y* to move to the right.

The standard of living is measured by the per capita real actual GDP: The average income generated by each individual within an economy

Although a small difference in growth rates may not seem to make a huge difference, compounded over time, smaller changes in growth rates can have a huge impact on economic growth!
-1% growth rate increases GDP by 10% in 10 years
-7% growth rate increases GDP by 100% in 10 years

Even a small change in the growth rate can cause major long term changes in terms of living standards- much more than gap-busting can, anyways...

Malthus thought that output would not be able to grow at a fast enough rate to keep up with population growth

In this unit, we're going to be studying the depressing, Neoclassical growth model, and then we'll be looking at some more optimistic modern growth models.

(As a general note, most asian countries have a much larger growth rate than the rest of the world, currently. This is because they are developing rather rapidly!)


What are some benefits of economic growth?
-Growth may increase the standard of living, as long as the economy is growing more quickly than the population. This means that people are able to buy more crap!
-Economic growth may help governments to alleviate poverty- the more national wealth a country has access to, the greater their ability to redistribute that wealth to those who are worse off.

What are the costs of economic growth?

1: Opportunity Cost: In order to allow for economic growth, individuals need to divert resources away from present consumption and into investment (ie: savings). For an example, a government has the option of spending 100 million dollars on new parks and public spaces now, OR it can spend that money on educating it's citizens, which won't generate any immediate benefit, but will create better workers and a stronger tax base 20 years into the future

2: Personal hardships to those who can't adapt to change (ie: the poor old blacksmith who goes out of business and doesn't want to retrain for a new job more befitting of the information age)

-Resource Depletion
-Global Warming
-Financial Meltdown
-Reduced Happiness (if you want to see this sort of thing in action, check out Carl Honore's "In Praise of Slowness"

Well, as we learned in the last chapter, in the long run, output is a function of the supply of factors (usually capital and labour, and this includes embodied increases in quality, not just quantity), and productivity (which can also by thought of as technological change)

In this chapter, we flip this idea around and reconfigure it, to state that we have four determinants of growth

1: Supply of labour: the quantity of labour
2: Human capital: the quality of labour (this is acquired through on-the-job training and education)
3: Physical capital: both the quantity and quality of plant, equipment, inventories, and residential construction
4: Technological change: This is sort of a catch-all category for all sorts of different changes, including changes in the productive process, innovation and invention (creative new ideas), new products, new organizations and many other things!

-Economic growth occurs in the long run, and related to increasing Y*, not output gaps

Long run growth is determined, largely, by investment and savings. In a nutshell, savings allows for more investment, and greater investment in productive capital increases potential output in the long run

In the short run, we assume that the interest rate is constant, so we use the equilibrium condition savings must = investments and use this to determine output
In the long run, we assume that potential GDP is constant, We also see that both savings and investment are a function of the interest rate, so we use the equilibrium condition S = I to determine what the equilibrium interest rate will be.

In this model of savings, we focus on public savings, which is a combination of private savings (Y* - C - T) and public savings (G - T)

NS = (Y* - C - T) + (T - G)
NS = Y* - C - G

When the interest rate increases, we know that consumption will decrease (because the opportunity cost of borrowing money has risen). When consumption decreases while income remains the same, national savings increases. As a result, high interest rates encourage more people to save money, and as a result, this creates a larger "pot" of loanable funds which accumulates in banks. Basically national savings as a function of interest rates is positively sloped.

What about investment????? Well, we use the marginal efficiency of investment curve to measure the degree of investment as a function of interest rates: this curve basically shows the demand for investment at each interest rate
This curve is negatively sloped. As interest rates rise, the opportunity cost of borrowing money to fund new investments also increases, which leads to decreased desired investment.

SO... what happens when we graph both desired national savings and desired investment together? We get two criss-crossing curves! The point where the two curves intersect is where NS = I: this is the equilibrium point- it does not change over time. If there is an excess supply of funds, this will mean that banks do not need to charge as much interest to prospective borrowers, so the interest rates will naturally fall, which drives up investment until it is equal to savings. Likewise, if there is excess demand for loanable funds, banks will know that that loaning out money when there are not many hard assets to cover their asses should the loan go unpaid is RISKY BUSINESS, so they will charge higher interest rates to compensate for this risk. Higher interest rates, likewise, discourages excess investment and encourages national savings until the economy is in equilibrium once again!

An increase in either public savings OR in the marginal efficiency of investment causes the level of equilibrium savings and investment to increase. This increased investment leads to long term increases in potential national income (because investment allows for the accumulation of new capital production factors). As such, although savings can be bad for an economy in the short run (because increased savings puts recessionary pressure on an economy), they are good in the long run, because they create opportunities for new growth! Woooooooooooo!

Macroeconomic Timespans

Macroeconomic Time Spans: Changes can have different effects over the long run than they do in the short run! This is just going to be a brief comparison exercise between the long run and the short run.


-Changes in national income are a function of factor utilization rate: for an example, the rate of employment. When more people are employed, more factors are being utilized, so national income increases
-National income is demand-induced: aggregate demand determines what the national income is going to be. The higher demand is, the higher the factor utilization rate will have to be in order to sate demand.
-Actual GDP, or Y determines national income: this means that there can be recessionary or inflationary output gaps
-Fiscal and monetary policy can affect both aggregate demand and actual national income
-Policies focus on shifting aggregate demand
-Gapbusting is the political objective
-Policies affect utilization rates
-Policies are focused on stabilizing real GDP at it's potential

-Changes in national income are a function of both the supply of factors (ie: the size of the labour force), and factor productivity (ie: how productive and useful, on average, each worker is). The larger the workforce, and the more productive that workforce is, the higher national income will be
-National income is supply-induced: even if demand increases, wages will simply adjust and price will change, but producers will still produce the same amount in the long run UNLESS their production capabilities change. The supply and productivity of factors affects supply, and therefore, can change production in the long run.
-Potential GDP (Y* or Yfe) is a better determinant of what the national income will be. While understanding that output gaps do occur thanks to the business cycle, it is long run aggregate supply which basically determines what GDP will be
-Fiscal and monetary policy have a neutral effect (or even a negative effect: if expansionary policies increase consumption at the expense of savings, then there will be a smaller "pot" for investors to borrow from, so investment will be lower in the long run, causing a lower long run GDP)
-Policies are aimed at affecting potential GDP
-Technological change is key
-Policies attempt to affect factor supply and productivity
-Growth is the political goal


Cool! =D

Honestly, just read the chapter for this one: it's short, and it makes more sense than the class notes...

Supply and Demand-Side Economics

Long-run aggregate supply, however, can shift if the potential national income shifts. When potential national income increases, this brings the equilibrium price level down, and the equilibrium level of GDP up in the long run. Neoclassical economists believe that policies which intend to bring real economic growth and betterment should focus on shifting potential national income to the right (increasing it): they believe that policies which only focus on increasing aggregate demand merely cause price-inflation in the long run.

So, for a classical economist, instead of using short term fiscal policy "gap-busting" to correct short term deviations from potential national income (boosting or reducing government expenditures to correct recessionary and inflationary gaps), policies should focus on brining potential national income forward, and closing the gap through increased potential economic growth! We call this SUPPLY-SIDE ECONOMICS

SO... let's say that an economy is in an inflationary state... there are a few things which policy-makers can do to fix this

1: They can do nothing. The chain and anchor system of long term economic adjustment will make wages higher, which shifts AS to the left and brings the economy back to Y*, but with a higher price level
2: The government could engage in some "gap-busting" policies (ie: they could raise taxes and decrease expenditures to kick aggregate demand back to the left, which would bring equilibrium GDP back to its potential levels)
3: The government could focus on increasing long run aggregate supply. This is also called Reaganomics: some policies in with vein include cutting personal income taxes (which increases incentives to work), cutting corporate income taxes (which increases production and investment). This shifts LRAS to the right to close the gap, and arguably, there is no negative effect on overall tax revenues, despite these cuts (because the increased long run equilibrium national income creates a larger tax base, so the government is still able to generate the same amount of revenue, despite taxing at lower rates).


Although these sorts of policies may increase LRAS, critics note that decreases in personal income tax also increase disposable income, which drives consumption upward. Also, decreases in corporate income tax are likely to cause corporations to increase their levels of investment. Thus, while LRAS will shift to the right, aggregate demand will also shift to the right, and the inflationary gap will persist, even if the economy's productive potential grows. This means that economies where supply side economic policies are instated will experience EVEN LARGER price inflation.


There are two different models we use for the economy: the short run model and the long run model. These two models are very different.

Fiscal policies which are based on the long run model is focused on increasing economic growth by increasing either labour, capital, or technology. These are factors which cause the potential national income to shift, and thus, they create long-run changes in economic potential.

The short run model, on the other hand, deals with temporary fluctuations in the economy which causes GDP to fall above or below potential: this is the economy model which is centered around the business cycle. Most policies in this vein are based around gap-busting, or eliminating recessionary and inflationary gaps.

It is not particularly difficult to determine the direction of the shift which must be kickstarted by fiscal policies: rather, it is the mixture and the magnitude which is hard to determine (for an example, if lowering taxes is likely to eliminate a recessionary gap, the question which the government must ask is how much of a tax cut should be given, how long should these cuts persist for, and which taxes should be affected by the cut).

-This is meant to damped the fluctuations caused by the business cycle
-This reduces the amplitude of the fluctuations (so recessionary and inflationary gaps are less extreme)

While the automatic economic adjustment which occurs thanks to natural wages shifts WILL bring economies back to potential GDP, one problem is that the natural adjustment process can take a very long time, and while the economy is adjusting to reduce a recessionary gap, unemployment will be high, and the economy will remain unproductive for a long while. Government stabilization policies can fix recessionary gaps a lot more quickly by increasing government expenditures and decreasing taxation. This boosts aggregate demand, and shifts equilibrium GDP back to Y* a lot more quickly than the natural AS shift to the right would have.

Contractionary fiscal policy works in a very similar way: if there is an inflationary gap, the government increases taxation and decreases government expenditure to shift aggregate demand to the right, thus bringing equilibrium GDP back to Y* much faster than the natural AS shift to the left would have.


In a recession, the natural tendency is for individuals to increase savings: while such prudent actions may benefit individuals, on a larger aggregate level, frugality decreases consumption, and therefore, it also reduces aggregate expenditures, aggregate demand, and GDP as a whole. As a result, this psychological tendency towards thriftiness in a recession can exacerbate recessionary gaps. A historical example of this occurred in the great depression when governments actually RASIED taxes as a response to the hard economic times.

Note* this negative economic result of savings only really applies to the short run: in the short run, increased savings means decreased consumption, and therefore decreased aggregate demand. In the long run, however (as we will learn in the next chapter), an increase in savings facilitates an increase in investment, which leads to a higher aggregate demand.

AUTOMATIC FISCAL STABILIZATION: This refers to built-in tax and expenditure rates which automatically stabilize the business cycle without the government having to specifically set up any policies
-Basically, tax 'n spend systems decrease the simple multiplier, so injections and withdrawals from the economy create smaller shifts in GDP.
-Automatic stabilization can be represented by the slope of the budget function (as GDP increases, there are more withdrawals from the economy)
-Discretionary stabilization (ie: expansionary and contractionary policies) can be represented by a shift in the budget function (so governments are taxing and spending at different rates for the same national income rate)
-Taxes aren't the only automatic stabilizer: other ones include employment insurance and welfare payments (which are forms of withdrawals or expenditures)

Why not just increase expenditures and lower taxes to fight unemployment???


There can be policy lags- so by the time a budgetary policy gets through the political process and takes effect, it may already be obsolete, or even counter-productive (remember, stabilization policy is extremely time-sensitive)

Also, economists recognize that many households are not "fooled" by short term changes in tax structures. Many households base their spending on what they believe their long term incomes are going to be (as Milton Friedman predicted), so short term changes in taxation which temporarily boosts income may not cause changes in spending habits.

Finally, most economists believe that fiscal policy creates too broad and general a change in the economic environment to fine tune an economy for optimal performance. While stabilization policy may be useful when large, sweeping economic changes are required, many economists believe that it is unnecessary overkill for small economic imbalances which will correct themselves.


While increased government purchases lead to increased AE, AD, and GDP in the short run, in the long run, they may "crowd out" private-sector consumption and investment
Similarly, while decreased taxes may increase AE, AD, and GDP in the short run, the long run effect is less clear. On the one hand, some economists believe that decreased taxes may increase investment and incentive to work in the long run, thus drumming up GDP. On the other hand, some economists believe that decreased taxes may crowd out public spending on public goods (case and point, check out Alberta's decaying public infrastructure)

Friday, February 12, 2010

Supply Shocks and Other Important Things!

SUPPLY SHOCKS: These also correct themselves in the long-run, but unlike demand shocks, these do not cause any net changes in the price level.

-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.
-There is now a recessionary gap in the economy, and this will cause unemployment to rise
-As unemployment rises, firms can get away with paying their workers less, so wages fall
-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level
-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level
-As unemployment falls wages rise (overtime and worker retention)
-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)



Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)



The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)


LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*

LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*

The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant



Factor Prices and the Output Gap!

Oh dear god, am I ever behind schedule for these notes...

Okay, today, we're going to have a look at what happens to our economic model when we allow factor prices (this usually refers to wages) to vary. Up until this point, we've been assuming that factor prices remain constant, but in real life, that isn't necessarily the case.

Here are some things you'll probably need to know about wages and the economy, and how they relate to demand shocks:

If the economy is in a recessionary gap (think post-2008)
-Actual income is lower than potential income
-There is an excess supply of labour (there are a lot more people going around trying to find jobs in a recession than firms are willing to hire)
-This excess supply of labour means that companies can lower wages without having to worry about losing workers
-By lowering wages, producers effectively decrease their average costs
-As a result, the short run aggregate supply curve will shift to the right (remember, decreased costs allow firms to increase production at every output price level)
-IMPORTANT: This adjustment happens relatively slowly, because it takes longer to lower wages than to raise wages (firms have to fight with unions, and it takes a while to agree on a lower wage rate: people don't like to be paid less)
-So... given some time, recessionary gaps will correct themselves, and unemployment will fall back to normal levels. Also, this kind of an adjustment causes the price level to decrease

If the economy is in an inflationary gap (for an example, Alberta circa 2007)
-Actual income is greater than potential income
-There is an excess demand of labour (there are not enough workers to supply firms' increasing demands, which is why you have fifteen year olds working in restaurants and making $12/hour during economic boom-times... it's ridiculous!)
-This excess demand of labour means that firms have to pay higher wages to entice new workers to stay on, or alternately, to reward current workers for working overtime
-This means that average costs increase for firms
-This increase in costs shifts short run aggregate supply to the left (increased costs force firms to decrease production at every output price level)
-IMPORTANT: This is a fast change: wages rise relatively quickly in good times, so this natural return to economic equilibrium is relatively quick.
-So... in the long run, the price level increases, and production decreases, bringing us back to equilibrium... yah!

-Booms cause wages to rise quickly
-Recessions cause wages to fall slowly

ALSO, you should probably know about the Phillips curve!

Basically, the phillips curve shows us that as employment increases, rate of wages become lower. In other words, in times were there is lots of unemployment (read: recessions), the wage rates will fall. Conversely in times when unemployment is high (booms), the wage rates will increase!

Basically, a good way to think about long run economic adjustment is to imagine that Y* (potential GDP) is like an anchor, and that short run aggregate supply is a chain. We have have demand shocks which shift the economy around for a little while, but because these demand shocks affect wage rates, which in turn, affects supplier costs, the short run aggregate supply will always eventually bring the economy back to it's potential level!

We can practice figuring out what happens with supply and demand shocks in the long run, but basically, all you need to know is what I've already told you.
-Inflationary gaps cause increases in prices in the long run
-Recessionary gaps cause decreases in prices in the long run
-Production will eventually shift back to its potential levels
-Also, for economies where wages are "stickier" (less flexible), recessions are likely to last longer, because the wage adjustment does not occur as quickly
-Recessionary and inflationary gaps WILL disappear on their own, but but discretionary fiscal policy can speed up the process a LOT!