Long term and short term (2023)

Figure 22.4Natural employment and long-run aggregate supply

When the economy reaches its natural level of employment, as shown in Panel (a) at the intersection of the labor demand and supply curves, it reaches its potential output, as shown in Panel (b) by the labor curve. long run vertical aggregate supplyLRASnoY_PAG.

Figure 22.5long term balance

The long-run equilibrium occurs at the intersection of the aggregate demand curve and the aggregate supply curve in the long run. For the three aggregate demand curves shown, long-run equilibrium occurs at three different price levels, but always at a level of output of $12 trillion per year, which corresponds to potential output.

Figure 22.6Derivation of the short run aggregate supply curve

The economy shown here is in long-run equilibrium at the intersection ofADVERTS₁with the long-run aggregate supply curve. If aggregate demand increases toADVERTS₂, in the short run, both real GDP and the price level increase. If aggregate demand falls toADVERTS₃In the short run, both real GDP and the price level fall. A line drawn through points A, B, and C traces the short-run aggregate supply curve.SARS.

Figure 22.7Short-run changes in aggregate supply

A reduction in aggregate supply in the short run shifts the curveSARS₁forSARS₂in panel (a). An increase moves it to the right toSARS₃, as shown in Panel (b).

wage rigidity

Wage contracts set nominal wages for the duration of the contract. The duration of the salary contracts ranges from one week or one month for temporary staff, one year (teachers and professors usually have temporary contracts) and three years (for most unionized workers employed under the main agreements collective). The existence of such explicit contracts implies that both workers and companies agree to some salary at the time of negotiation, although economic conditions may change while the agreement is in force.

Think about your own job or a job you once had. Chances are, you go to work every day knowing what your salary will be. Your salary does not fluctuate overnight with changes in supply or demand. You may have a formal contract with your employer that specifies what your salary will be for a certain period of time. Or you may have an informal understanding that defines your salary. Whatever the nature of your contract, your salary is "locked in" for the duration of the contract. Your salary is an example of a fixed price.

One of the reasons that workers and companies may be willing to accept long-term nominal wage contracts is that negotiating a contract is an expensive process. Both parties must keep themselves adequately informed about market conditions. When unions are involved, wage negotiations raise the possibility of a labor strike, an eventuality for which companies can prepare by hoarding additional inventory, also a costly process. Even when unions are not involved, the time and energy spent discussing wages dwarfs the time and energy spent producing goods and services. Furthermore, workers may simply prefer to know that their nominal wage will be fixed for a period of time.

Some contracts attempt to account for changing economic conditions, such as inflation, through cost-of-living adjustments, but even these relatively simple contingencies are not as widespread as one might think. One reason might be that a firm is concerned that as the aggregate price level rises, the prices of the goods and services it sells may not move at the same rate. Additionally, cost of living or other contingencies add complexity to contracts that both parties may want to avoid.

Even markets where workers are not employed under explicit contracts seem to behave as if such contracts exist. In these cases, wage rigidity may result from a desire to avoid the same uncertainty and adjustment costs that explicit contracts avoid.

Finally, minimum wage laws prevent wages from falling below the legal minimum, even though unemployment is rising. Unskilled workers are particularly vulnerable to changes in aggregate demand.

price fixing

The stickiness of other prices becomes easier to explain in light of the arguments about the stickiness of money wages. Since wages are a major component of the total cost of doing business, sticky wages can lead to sticky output prices. With stable nominal wages, at least some companies can adopt a "wait and see" attitude before adjusting their prices. During that time, can they evaluate information about why sales are increasing or decreasing (is the change in demand temporary or permanent?) get irritated by a price increase, for example? Will competing firms keep up with price changes?).

Meanwhile, companies may prefer to adjust output and employment in response to changing market conditions, product price aside. Quantity adjustments have costs, but companies may assume that the associated risks are less than those associated with price adjustments.

Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices. In some cases, companies must print new price lists and catalogs and notify customers of price changes. Doing this too often can damage customer relationships.

Yet another explanation for sticky prices is that firms may have explicit long-term contracts to sell their products to other firms at specified prices. For example, energy companies often purchase their coal or oil inputs through long-term contracts.

Taken together, these reasons for price and wage stickiness explain why aggregate price adjustment may be incomplete, in the sense that the change in the price level is insufficient to maintain real GDP at its potential level. These reasons do not lead to the conclusion that price adjustments do not occur. But adjustments take some time. During this period, the economy may remain above or below its potential level of output.

A change in the cost of health care

In the United States, most people receive health insurance for themselves and their families through their employers. In fact, it's quite common for employers to pay a large percentage of employees' health insurance premiums, and this benefit is often included in employment contracts. As the cost of health care has increased over time, companies have had to pay higher and higher health insurance premiums. With short-term fixed nominal wages, an increase in health insurance premiums paid by companies increases the cost of employing each worker. It affects the cost of production in the same way as higher wages. The result of higher health insurance premiums is that companies will choose to employ fewer workers.

Suppose the economy initially operates in short-run equilibrium at the intersection ofADVERTS₁miSARS₁, with a real GDP ofY₁and a price level ofPAG₁, as it is shown inFigure 22.8 "An increase in health insurance premiums paid by companies". This is the initial equilibrium price and short-run output. The increase in the cost of labor shifts the short-run aggregate supply curve toSARS₂. The price level rises toPAG₂and real GDP falls toY₂.

A reduction in health insurance premiums would have the opposite effect. There would be a shift to the right in the short-term aggregate supply curve, with pressures for a fall in price levels and an increase in real GDP.

A shift in government purchases

Suppose the federal government increases its spending on highway construction. This circumstance leads to an increase in US government purchases and an increase in aggregate demand.

Assuming that no other changes affect aggregate demand, the increase in government purchases shifts the aggregate demand curve by an amount times the initial increase in government purchases toADVERTS₂noFigure 22.9 "An increase in government purchases". Real GDP rises fromY₁forY₂, while the price level rises fromPAG₁forPAG₂. Note that the increase in real GDP is less than it would have been if the price level had not increased.

On the other hand, a reduction in government purchases would reduce aggregate demand. The aggregate demand curve shifts to the left, pushing down both the price level and real GDP.

In the short run, real GDP and the price level are determined by the intersection of the short-run aggregate demand and aggregate supply curves. Remember, however, that the short run is a period in which sticky prices may prevent the economy from reaching its natural level of potential employment and output. In the next section, we will see how the model fits to bring the economy to equilibrium in the long run and what can be done to bring the economy back to its natural level of potential employment and output.