1 of 18 Chapter 25 The Difference Between Short-Run and Long-Run Macroeconomics

2 of 18 Copyright © 2005 Pearson Education Canada Inc. Learning Objectives 1. Explain why economists think differently about short-run and long-run changes in macroeconomic variables. 3. Show that short-run changes in GDP are mostly caused by changes in factor utilization, whereas long-run changes in GDP are mostly caused by changes in factor supplies and productivity. 2. Explain why any changes in GDP can be decomposed into changes in: factor supply, the utilization rate of factors, and productivity. 4. Recognize that macroeconomic policies will only have a long-run effect on output if they influence factor supplies or productivity.

3 of Two Examples Inflation and Interest Rates in Canada Because inflation erodes the value of money, an increase in inflation pushes up nominal interest rates. It causes lenders to demand a higher return The Governor of the Bank of Canada argues that in order to reduce inflation and interest rates, the Bank must reduce the growth rate of the money supply. (We will see why next week.) But this has the immediate effect of increasing interest rates. How can this be sensible?

4 of 18 In the long run, however, the downward pressure on wages caused by higher unemployment will cause inflationary pressures to fall. As inflation falls, so will interest rates. In the short run, the tighter credit conditions will make both nominal and real interest rates increase. Aggregate expenditure will fall, causing national output to fall and unemployment to rise. The key to this puzzle is recognizing the different short-run and long-run effects of monetary policy. We will work through this example next week

5 of 18 Copyright © 2005 Pearson Education Canada Inc. Saving and Growth in Japan For the last decade, Japan’s economy has been stagnant. Some economists argue that the stagnation comes from too much saving (and too little spending). But most economists also agree that Japan’s tremendous economic success since the Second World War has been due in part to its high saving rate — high saving means high rates of capital accumulation and high growth rates. How can both views be correct? The key is recognizing the different short-run and long-run effects of saving.

6 of 18 Copyright © 2005 Pearson Education Canada Inc. In the short run, an increase in firms’ and households’ desired saving causes firms to spend less on investment goods and households to spend less on consumer goods. In the long run, however, greater saving leads to a larger pool of funds, which drives down interest rates (the price of credit) and makes investment more attractive. The reduction in spending may cause an economic slump. More investment in capital leads to increases in the economy’s long-run productive potential.

7 of 18 Copyright © 2005 Pearson Education Canada Inc. A Need to Think Differently Short run: changes in economic conditions tend to cause changes in output and employment, with relatively small changes in wages or prices. Long run: wage and price adjustment takes place — a process set in motion by the short-run changes in output and employment. Think of the short run as a period of many months, maybe even three of four years. In contrast, think of the long run as anything beyond that. What do we mean by “short run” and “long run”?

8 of 18 Copyright © 2005 Pearson Education Canada Inc Accounting for Changes in GDP GDP Accounting: The Basic Principle If we want to account for changes in GDP, we can account for changes in the component parts. Think of the following equation, which is obviously true: GDP = F x (F E /F) x (GDP/F E ) where: F is the amount of factors, and F E is the amount of employed factors. What are the three component parts of GDP?

9 of 18 Copyright © 2005 Pearson Education Canada Inc. 1. F is the factor supply. Any change in GDP must be the result of a change in factor supply, a change in factor utilization, or a change in productivity. 3. GDP/F E is a simple measure of productivity. 2. F E /F is the factor utilization rate. GDP = F x (F E /F) x (GDP/F E ) How do these components change over time?

10 of Factor Supplies. The supplies of labour, capital and natural resources change only gradually. These changes are therefore important for explaining long-run changes in output, but relatively unimportant for explaining short-run fluctuations. 2. Productivity. This also changes only gradually, and thus is most important for explaining long-run changes in output, but less important for explaining short-run fluctuations. 3. Factor Utilization Rate. This fluctuates a lot in response to changes in the demand for firms’ output. But over the long run, adjustments in factor prices bring the factor utilization rate back to its “normal” level. It is therefore not very important for explaining long-run changes in output.

11 of 18 GDP Accounting: An Application To simplify, consider only a single factor of production — labour. Letting L be the labour force and E be the level of employment, the modified decomposition equation is: GDP = L x (E/L) x (GDP/E) The employment rate (E/L) is the fraction of labour force actually employed. GDP/E is a simple measure of labour productivity (output per worker). How have these components actually changed over time in Canada?

12 of 18 Copyright © 2005 Pearson Education Canada Inc. Labour Force The labour force grows substantially over long periods of time but does not have significant cyclical fluctuations.

13 of 18 Copyright © 2005 Pearson Education Canada Inc. Productivity Productivity has more short-term fluctuations than the labour force, but most of the action is still over long periods of time.

14 of 18 Copyright © 2005 Pearson Education Canada Inc. Employment Rate The employment rate has little long-run trend, but fluctuates greatly over the course of the business cycle.

15 of 18 Copyright © 2005 Pearson Education Canada Inc. For understanding the causes of long-run changes in GDP, we must understand the causes of labour force growth and productivity growth. In contrast, for understanding the causes of short-run changes in GDP, we must understand the causes of changes in the employment rate. Summing Up

16 of 18 Copyright © 2005 Pearson Education Canada Inc Policy Implications When studying short-run fluctuations, economists ignore changes in potential output and focus instead on the deviations of actual output from potential. When studying long-run changes, economists ignore such deviations and focus instead on changes in potential output. Fiscal and monetary policy affect the short-run level of GDP because they alter the level of demand. But unless they are able to affect the level of potential output, they will have no effect on GDP in the long run.

17 of 18 Copyright © 2005 Pearson Education Canada Inc. Looking Ahead Short-run changes in GDP are mostly accounted for by changes in the factor utilization rate, while long-run changes in GDP are mostly accounted for by changes in factor supplies and productivity. We are now ready to take the next step and examine the causes of long-run growth. We have examined in detail the behaviour of the economy in the short run, as well as the adjustment process that takes us from the short run to the long run.

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