NATIONAL INCOME & THE PRICE LEVEL IN THE LONG RUN

1. NATIONAL INCOME & THE PRICE LEVEL IN THE LONG RUN Chapter 32 - Lipsey

2. 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

3. FACTOR PRICES & THE OUTPUT GAP • Upward and downward wage pressures • Actual GDP exceeds potential GDP • Potential GDP exceeds actual GDP • Adjustment asymmetry

4. THE LONG-RUN CONSEQUENCES OF AGGREGATE DEMAND SHOCKS EXPANSIONARY SHOCKS

5. DEMAND SHOCK INFLATION (Fig 32.2) Induced shift in aggregate supply Autonomous increase in aggregate demand

6. THE LONG-RUN CONSEQUENCES OF AGGREGATE DEMAND SHOCKS CONTRACTIONARY SHOCKS

7. (FIG 32.3) – DEMAND SHOCK DEFLATION WITH FLEXIBLE WAGES Autonomous Falls In Aggregate Demand Induced Shift In Aggregate Supply

8. 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

9. LONG-RUN EQUILIBRIUM AND AGGREGATE SUPPLY (Fig. 32.5) When LRAS is vertical, aggregate supply determines Y*. Given Y*, aggregate demand determines equilibrium P.

10. NATIONAL INCOME IN THE SHORT & LONG RUN Three ways of increasing national income – Fig 32.6 A temporary increase in aggregate supply Permanent increases in aggregate supply An increase in AD

11. 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.

12. 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

13. THE BASIC THEORY OF FISCAL STABILIZATION REMOVAL OF A RECESSIONARY GAP – Fig 32.8 (1) Rightward shift in SRAS (2) Rightward shift in AD

14. THE BASIC THEORY OF FISCAL STABILIZATION REMOVAL OF A INFLATIONARY GAP – Fig 32.9 (1) Leftward shift in SRAS (2) Leftward shift in AD

15. 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

16. 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.

17. 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.

18. 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