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

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.

EXPANSIONARY SHOCKS

DEMAND SHOCK INFLATION (Fig 32.2)

Autonomous increase in aggregate demand Induced shift in aggregate supply

THE LONG-RUN CONSEQUENCES OF

AGGREGATE DEMAND SHOCKSThese 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

CONTRACTIONARY SHOCKS

(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)

Relates the price level and national income after all costs wages and other costs have been adjusted fully to long-run equilibrium

FIG: 32.4

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 THRIFTParadox 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