pcecon.com Class Notes

When the Curves Move...

Let’s start with an economy in long run equilibrium, with the price level equal to that anticipated by decision makers. The long run equilibrium is shown by the green dot (1) with the price level at 105.

Then, suppose a change in short run equilibrium occurs. For example, there may be an increase in aggregate demand due to a sudden increase in the wealth of consumers (one of the six things that increases aggregate demand). Producers and consumers will still make decisions based on their assumptions about the price level (in this case, it seems that buyers and producers still believe the price level will remain at 105, its old level). However, buyers are buying more than they previously did, since consumers have greater wealth. The following short run equilibrium results.

In this short run equilibrium, which is shown as point (2):
1. the price level is higher than what was expected (it’s 110 instead of 105)
2. the price level is higher than in the (previous) long run equilibrium
3. as a result of the higher price level, producers will produce more output in the short run than in the previous long run equilibrium, since resource costs will not keep up with the higher price level for products (see below)
4. output (real GDP) will be higher than in long run equilibrium (and higher than the potential, sustainable, full employment level).
5. employment is greater than full employment
6. unemployment is lower than the natural rate (this can occur temporarily)
7. cyclical unemployment is negative (which can happen temporarily)
8. the real values of wages and resource prices will be lower than their lower than their long run equilibrium levels (due to the higher than expected price level)
9. real interest rates will be lower than long run equilibrium values (due to the higher than expected price level)

Effect of Short Run Equilibrium on Wages and Resources

This short run equilibrium will affect the resource market. As the aggregate demand begins to move rightward, producers expand their production in response, and thus increase demand for resources. However, most resource owners and workers will not realize that prices of goods and services are also on the way up. They supply their labor and resources based on the assumption that the price level will stay at its original level (105 in this example). As a result, they will agree to sell their labor and other resources at prices that will not take the higher price level (110) into account:

In nominal (money) terms, the wage and resource prices may even go up. However, the increase will not be enough to keep up with the rising price level for goods and services. In real terms, wages and resource prices actually fall in the short run as the price level goes up. This is what stimulates producers to increase real output in the short run; the price level of goods and services they produce is going up, but the prices of resources and wages of workers are not keeping up.
Something similar is happening in the market for loans (which is why the real interest rate will be lower in the short run equilibrium), but it is resource prices that hold the important key to what happens next.

Return to the Long Run Equilibrium

Since the price level is not what was anticipated, this short run equilibrium is essentially built on decisions that will be altered in the long run, as the true price level is recognized, and as people have time to change their decisions (and anticipations). All decisions that were based on the incorrect anticipated price level will eventually be altered. This includes decisions by workers and other resource sellers to sell supply their resources to producers. Over time, as workers and owners of resources realize that the price level is higher, they will expect and negotiate for higher pay (to keep up with inflation).
This may take time, since there will be delays in realizing that the price level has increased, and also because contracts to supply labor and other resources may have to expire before new agreements (with the higher resource prices and wages) can be made. After the higher price level is included in the expectations and supply decisions of workers and resource owners, the supply of resources will move to the left to reflect this. Real wages will rise (back to their original level):

As the supply for labor and resources reflects more realistic price level expectations, real wages and resource prices will rise. This will cause the short run aggregate supply to fall. It will also result in less employment of resources (a return to full employment).
Eventually, a new long run equilibrium will be established, reflecting the restored real wages and resource prices.
The process restoring the long run equilibrium is called the"self correcting mechanism." The self correcting mechanism will occur whenever the economy is not at full employment. If employment is larger than full employment, as in the above example, wages and resource prices will rise to restore full employment. When the level of employment is less than full employment, wages and resource prices will fall to restore full employment.

At the final long run equilibrium (3),
1. the price level is as expected (it's 117 now, and that’s consistent with expectations)
2. the price level is higher than in the previous long run equilibrium
3. even though the price level is higher than the previous equilibrium, producers do not want to produce more than the long run potential GDP, since resource prices have caught up with product prices.
4. output (real GDP) will be the potential, sustainable, full employment level.
5. employment is equal to full employment
6. unemployment is at the natural rate
7. cyclical unemployment is zero
8. real wages return to their original level, even though nominal wages are higher than before.
9. real interest rates will rise back to their original level, as the economy slides up the aggregate demand curve to the new long run equilibrium.

Copyright 2006 by Ray Bromley. For economics information, and other information about Ray Bromley, visit www.raybromley.com. Permission to copy for educational use is granted, provided this notice is retained. All other rights reserved.
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