From the Short Run to the Long Run

As you can see in Figure 12-8, the economy normally produces more or less than potential output: actual aggregate output was below potential output in the early 1990s, above potential output in the late 1990s, below potential output for most of the 2000s, and significantly below potential output after the recession of 2007–2009. So the economy is normally on its short-run aggregate supply curve—but not on its long-run aggregate supply curve. So why is the long-run curve relevant? Does the economy ever move from the short run to the long run? And if so, how?

The first step to answering these questions is to understand that the economy is always in one of only two states with respect to the short-run and long-run aggregate supply curves. It can be on both curves simultaneously by being at a point where the curves cross (as in the few years in Figure 12-8 in which actual aggregate output and potential output roughly coincided). Or it can be on the short-run aggregate supply curve but not the long-run aggregate supply curve (as in the years in which actual aggregate output and potential output did not coincide). But that is not the end of the story. If the economy is on the short-run but not the long-run aggregate supply curve, the short-run aggregate supply curve will shift over time until the economy is at a point where both curves cross—a point where actual aggregate output is equal to potential output.

PITFALLS

PITFALLS: ARE WE THERE YET? WHAT THE LONG RUN REALLY MEANS

ARE WE THERE YET? WHAT THE LONG RUN REALLY MEANS
We’ve used the term long run in two different contexts. In an earlier chapter we focused on long-run economic growth: growth that takes place over decades. In this chapter we introduced the long-run aggregate supply curve, which depicts the economy’s potential output: the level of aggregate output that the economy would produce if all prices, including nominal wages, were fully flexible. It might seem that we’re using the same term, long run, for two different concepts. But we aren’t: these two concepts are really the same thing.

Because the economy always tends to return to potential output in the long run, actual aggregate output fluctuates around potential output, rarely getting too far from it. As a result, the economy’s rate of growth over long periods of time—say, decades—is very close to the rate of growth of potential output. And potential output growth is determined by the factors we analyzed in the chapter on long-run economic growth. So that means that the “long run” of long-run growth and the “long run” of the long-run aggregate supply curve coincide.

Figure 12-9 illustrates how this process works. In both panels LRAS is the long-run aggregate supply curve, SRAS1 is the initial short-run aggregate supply curve, and the aggregate price level is at P1. In panel (a) the economy starts at the initial production point, A1, which corresponds to a quantity of aggregate output supplied, Y1, that is higher than potential output, YP. Producing an aggregate output level (such as Y1) that is higher than potential output (YP) is possible only because nominal wages haven’t yet fully adjusted upward. Until this upward adjustment in nominal wages occurs, producers are earning high profits and producing a high level of output. But a level of aggregate output higher than potential output means a low level of unemployment. Because jobs are abundant and workers are scarce, nominal wages will rise over time, gradually shifting the short-run aggregate supply curve leftward. Eventually it will be in a new position, such as SRAS2. (Later in this chapter, we’ll show where the short-run aggregate supply curve ends up. As we’ll see, that depends on the aggregate demand curve as well.)

From the Short Run to the Long Run In panel (a), the initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2. In panel (b), the reverse happens: at the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. High unemployment eventually leads to a fall in nominal wages over time and a rightward shift of the short-run aggregate supply curve.

In panel (b), the initial production point, A1, corresponds to an aggregate output level, Y1, that is lower than potential output, YP. Producing an aggregate output level (such as Y1) that is lower than potential output (YP) is possible only because nominal wages haven’t yet fully adjusted downward. Until this downward adjustment occurs, producers are earning low (or negative) profits and producing a low level of output. An aggregate output level lower than potential output means high unemployment. Because workers are abundant and jobs are scarce, nominal wages will fall over time, shifting the short-run aggregate supply curve gradually to the right. Eventually it will be in a new position, such as SRAS2.

We’ll see shortly that these shifts of the short-run aggregate supply curve will return the economy to potential output in the long run.

!worldview! ECONOMICS in Action: Sticky Wages in the Great Recession

Sticky Wages in the Great Recession

We’ve asserted that the aggregate supply curve is upward-sloping in the short run mainly because of sticky wages—in particular, because employers are reluctant to cut nominal wages (and workers are unwilling to accept wage cuts) even when labor is in excess supply. But what is the evidence for wage stickiness?

Sticky Wages in the Great Recession Sources: Bureau of Labor Statistics; Daly and Hobijn.

The answer is that we can look at what happens to wages at times when we might have expected to see many workers facing wage cuts because similar workers are unemployed and would be willing to work for less. If wages are sticky, what we would expect to find at such times is that many workers’ wages don’t change at all: there’s no reason for employers to give them a raise, but because wages are sticky, they don’t face cuts either.

And that is exactly what you find during and after the Great Recession of 2007–2009. Mary Daly and Bart Hobijn, economists at the Federal Reserve Bank of San Francisco, looked at data on wage changes for a sample of workers. Their findings are shown in Figure 12-10: as unemployment soared after 2007, so did the fraction of U.S. workers receiving the same wage as they did a year ago.

Similar results can be found in European nations facing high unemployment, such as Spain. The Great Recession provided strong confirmation that wages are indeed sticky.

When unemployment soared in the face of the economic slump following the 2008 financial crisis, you might have expected to see widespread wage cuts. But employers are reluctant to cut wages. So what we saw instead was a sharp rise in the number of workers whose wages were flat—neither rising nor falling.

Quick Review

  • The aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied.

  • The short-run aggregate supply curve is upward sloping: a higher aggregate price level leads to higher aggregate output given that nominal wages are sticky.

  • Changes in commodity prices, nominal wages, and productivity shift the short-run aggregate supply curve.

  • In the long run, all prices are flexible, and changes in the aggregate price level have no effect on aggregate output. The long-run aggregate supply curve is vertical at potential output.

  • If actual aggregate output exceeds potential output, nominal wages eventually rise and the short-run aggregate supply curve shifts leftward. If potential output exceeds actual aggregate output, nominal wages eventually fall and the short-run aggregate supply curve shifts rightward.

12-2

  1. Question 12.2

    Determine the effect on short-run aggregate supply of each of the following events. Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve.

    1. A rise in the consumer price index (CPI) leads producers to increase output.

    2. A fall in the price of oil leads producers to increase output.

    3. A rise in legally mandated retirement benefits paid to workers leads producers to reduce output.

  2. Question 12.3

    Suppose the economy is initially at potential output and the quantity of aggregate output supplied increases. What information would you need to determine whether this was due to a movement along the SRAS curve or a shift of the LRAS curve?

Solutions appear at back of book.