Macroeconomics — Short-Run and Long-Run Adjustment in AD-AS

Macroeconomics — The Vertical Long-Run Supply Curve Is Not a Jump but a Path Along Which Wages Catch Up

Chapter 8 compared the short-run and long-run results of a monetary expansion. This chapter looks at the time in between. The speed of the move from short run to long run determines how long the effects of stabilization policy last and how long a recession persists.

1. The adjustment mechanism

Short-run aggregate supply rests on expected prices and wage contracts. When output is above potential, the labour market tightens and wages rise, and firms pass the higher costs on in prices. Seeing higher prices, people raise their expectations. As a result the short-run aggregate supply curve shifts up and output returns to potential.

2. The year-by-year path

In the economy of Chapter 8, suppose the nominal money supply rises by 10% (AD: $Y=328+79.2/P$, $Y^*=400$, $1/\alpha=0.002$). If each year’s expected price level equals the previous year’s price level, the path is as follows.

The gap shrinks by about 13% a year. With these numbers it takes about five years for the gap to halve. The speed of adjustment depends on the slope of short-run aggregate supply (how sensitive wages and prices are to the gap) and on how quickly expectations change. If expectations are rational and the monetary expansion was announced, the expected price level may jump to 1.1 at once, leaving almost no effect on output (Chapter 9).

3. Why adjustment in a recession is slower

When aggregate demand falls and output drops below potential, in theory wages and prices fall, real balances rise and output recovers. But this path is slower and less certain than on the expansion side.

• Downward nominal wage rigidity: workers strongly resist cuts in nominal wages, and firms avoid them for fear of hurting morale. If wages do not fall, SRAS does not shift down.
• Debt deflation: when prices fall, the real burden of debt fixed in nominal terms rises. As debtors cut spending, aggregate demand falls further and prices fall further. Fisher proposed this channel to explain the Great Depression. Falling prices can actually reduce aggregate demand.
• Hysteresis: when unemployment lasts, skills erode and job seekers become discouraged, so cyclical unemployment turns into structural unemployment. Potential output itself falls, moving the “long-run equilibrium” towards the recession.

4. The path after a supply shock

Whether a shock is temporary or permanent is hard to tell when it hits. Treating a permanent shock as temporary and propping up aggregate demand amounts to trying to hold output above potential, and inflation accelerates.

Check your understanding

If on the path above the output gap shrinks each year to 87% of the previous year’s gap, how many years does it take for the first-year gap of 6.2 to fall below 1? From $6.2\times 0.87^n<1$, $n>\ln(6.2)/\ln(1/0.87)\approx 13.1$, so about 14 years. If expectations followed actual prices only halfway each year, adjustment would be slower still. The calculation shows how much the slope and the way expectations are formed govern the length of adjustment.

References

• N. Gregory Mankiw, Macroeconomics, ch. 14
• Irving Fisher, “The Debt-Deflation Theory of Great Depressions,” Econometrica (1933)
• Olivier Blanchard and Lawrence Summers, “Hysteresis and the European Unemployment Problem,” NBER Macroeconomics Annual (1986)
• Milton Friedman, “The Role of Monetary Policy,” American Economic Review (1968)