Chapter 15 - Modern Macroeconomics: From the Short Run to the Long Run

15.1 Linking to the Short Run and the 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.

Wages and prices will all tend to increase together during booms when GDP exceeds its full-employment level or potential output.
Wages and prices will fall together during periods of recessions when GDP falls below full employment or potential output.
To attract workers and prevent them from leaving, firms will raise their wages.
Wage-price spiral: The process by which changes in wages and prices cause further changes in wages and prices.
When the economy is producing below full employment or potential output, the process works in reverse.

Aggregate Demand Curve: A curve shows the relationship between the level of prices and the quantity of real GDP demanded.
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.

If the 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.

Move from short run to long run:
- One alternative for policymakers is to do nothing, allowing the economy to adjust itself with falling wages and prices until it returns by itself to full employment.
- Another alternative is to use expansionary policies, such as open market purchases by the Fed or increases in government spending and tax cuts.
- Demand policies can also prevent a wage-price spiral from emerging if the economy is producing at a level of output above full employment.
Active economic policies are more likely to destabilize the economy if the adjustment is quick enough.

Liquidity trap: A situation in which nominal interest rates are so low, they can no longer fall; also known as the zero lower bound.

Political business cycle: The effect on the economy of using monetary or fiscal policy to stimulate the economy before an election to improve reelection prospects.

Lower interest rates stimulate investment spending and push the economy back toward full employment. All this works in reverse if output exceeds the economy’s potential output.
Why changes in wages and prices restore the economy to full employment:
- Changes in wages and prices change the demand for money
- This changes interest rates, which then affect aggregate demand for goods and services and ultimately GDP.

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.

The increase in government spending has no long-run effect on the level of output, only on the interest rate.
If the government spending went toward government investment projects, then it will have just replaced an equivalent amount of private investment.
Tax cuts initially will increase consumer spending and lead to a higher level of GDP. In the long run, however, adjustments in wages and prices restore the economy to full employment.

The term classical economics refers to the work of the originators of modern economic thought.

Classical economics is often associated with Say’s law, the doctrine that “supply creates its own demand.”
Spending on consumption and investment together would be sufficient so that all the goods and services produced in the economy would be purchased.
Keynes argued that there could be situations in which total demand fell short of total production in the economy for extended periods of time.

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.
Patinkin and Modigliani, there is insufficient aggregate demand to restore the economy to full employment.

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