Page 334 - Economics

CONFIRMING PAGES

PART FIVE
286
Long-Run Perspectives and Macroeconomic Debates
chapters (one is at our Internet site only), the renewed emphasis on the long run has produced
significant insights on aggregate supply, economic growth, and economic development. We will also
see that it has renewed historical debates over the causes of macro instability and the effectiveness of
stabilization policy.
Our goals in this chapter are to extend the analysis of aggregate supply to the long run, examine
the inflation-unemployment relationship, and evaluate the effect of taxes on aggregate supply. The
latter is a key concern of so-called supply-side economics .

From Short Run to Long Run eventually will rise to restore the purchasing power of an
hour of work. In our example, Jessica’s nominal wage will
Until now we have assumed the aggregate supply curve increase from $10 to $12, returning her real wage to $10
remains stable when the aggregate demand curve shifts. ( $12 1.2). But that adjustment will take time.
For example, an increase in aggregate demand along the
upsloping short-run aggregate supply curve raises both Short-Run Aggregate Supply
the price level and real output. That analysis is accurate Our immediate objective is to demonstrate the relationship
and realistic for the short run , which, you may recall from between short-run aggregate supply and long-run aggregate
Chapter 10, is a period in which nominal wages (and other supply. We begin by briefly reviewing short-run aggregate
input prices) do not respond to price-level changes. supply.
There are at least two reasons why nominal wages may Consider the short-run aggregate supply curve AS in
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for a time be unresponsive to changes in the price level: Figure 15.1 a. This curve is based on three assumptions:
• Workers may not immediately be aware of the extent (1) The initial price level is P , (2) firms and workers have
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to which inflation (or deflation) has changed their established nominal wages on the expectation that this price
real wages, and thus they may not adjust their labor level will persist, and (3) the price level is flexible both up-
supply decisions and wage demands accordingly. ward and downward. Observe from point a that at price
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• Many employees are hired under fixed-wage contracts. level P the economy is operating at its full-employment
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For unionized employees, for example, nominal wages output Q . This output is the real production forthcoming
f
are spelled out in their collective bargaining agree- when the economy is operating at its natural rate of unem-
ments for perhaps 2 or 3 years. Also, most managers ployment (or potential output.).
and many professionals receive set salaries established Now let’s review the short-run effects of changes in the
in annual contracts. For them, nominal wages remain price level, say, from P to P in Figure 15.1 a. The higher
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constant for the life of the contracts, regardless of prices associated with price level P increase firms’ reve-
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changes in the price level. nues, and because their nominal wages remain unchanged,
In such cases, price-level changes do not immediately give their profits rise. Those higher profits lead firms to increase
rise to changes in nominal wages. Instead, significant peri- their output from Q to Q , and the economy moves from
f
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ods of time may pass before such adjustments occur. a to a on aggregate supply AS . At output Q the economy
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Once contracts have expired and nominal wage adjust- is operating beyond its full-employment output. The firms
ments have been made, the economy enters the long run . make this possible by extending the work hours of part-time
Recall that this is the period in which nominal wages are and full-time workers, enticing new workers such as home-
fully responsive to previous changes in the price level. As makers and retirees into the labor force, and hiring and
time passes, workers gain full information about price-level training the structurally unemployed. Thus, the nation’s
changes and how those changes affect their real wages. For unemployment rate declines below its natural rate.
example, suppose that Jessica received an hourly nominal How will the firms respond when the price level falls,
wage of $10 when the price index was 100 (or, in decimals, say, from P to P in Figure 15.1 a? Because the prices they
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1.0) and that her real wage was also $10 ( $10 of nominal receive for their products are lower while the nominal
wage divided by 1.0). But when the price level rises to, say, wages they pay workers are not, firms discover that their
120, Jessica’s $10 real wage declines to $8.33 ( $10 1.2). revenues and profits have diminished or disappeared. So
As a result, she and other workers will adjust their labor they reduce their production and employment, and, as
supply and wage demands such that their nominal wages shown by the movement from a to a , real output falls to
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