How long is the long term and why is the answer important for
policymakers?
Of course, this is all just a prelude to the main event:
slapping these curves—AD, AS, and ASL (the long-run AS curve)—on
the same graph at the same time. Let’s start, as in Figure
23.5 , with just the short-run AS and AD curves. Their intersection
indicates both the price level P* (not to be confused with the
microeconomic price theory model’s p*) and Y* (again not to be
confused with q*). Equilibrium is achieved because at any P >
P*, there will be a glut (excess supply), so prices (of all goods
and services) will fall toward P*. At any P < P*, there will be
excess demand, many bidders for each automobile, sandwich, haircut,
and what not, who will bid prices up to P*. We can also now examine
what happens to P* and Y* in the short run by moving the curves to
and fro.
To study long-run changes in the economy, we need to add the
vertical long-run aggregate supply curve (ASL) to the graph.
As discussed above, if Y* is > or < Ynrl, the AS
curve will shift (via the labor market and/or inflation
expectations) until it Y* = Ynrl, as in Figure 23.6 . So
attempts to increase output above its natural rate will cause
inflation and recession. Attempts to keep it below its natural rate
will lead to deflation and expansion.
The so-called self-correcting mechanism described above
makes many policymakers uneasy, so the most activist among them
argue that the long-run analysis holds only over very long
periods. In fact, the great granddaddy, intellectually
speaking, of today’s activist policymakers, John Maynard Keynes,
once remarked, “[The l]ong run is a misleading guide to current
affairs. In the long run we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons they can
only tell us that when the storm is long past the ocean is flat
again.”www.bartleby.com/66/8/32508.html
Other economists (nonactivists, including monetarists like Milton
Friedman) think that the short run is short indeed and the long run
is right around the corner. Figuring out how short and long the
short and long runs are is important because if the nonactivists
are correct, policymakers are wasting their time trying to increase
output by shifting AD to the right: the AS curve will soon shift
left, leaving the economy with a higher price level but the same
level of output. Similarly, policymakers need do nothing in
response to a negative supply shock (which, as
noted above, shifts AS to the left) because the AS curve will soon
shift back to the right on its own, restoring both the price level
and output. If the activists are right, on the other hand,
policymakers can improve people’s lives by shifting AD to the right
to counter, say, the effects of negative supply shocks by helping
the AS curve to return to its original position or beyond.
The holy grail of economic growth theory is to
figure out how to shift Ynrl to the right because, if
policymakers can do that, it doesn’t matter how short the long term
is. Policymakers can make a difference—and for the better. The real
business cycle theory of Edward Prescott suggests that real
aggregate supply shocks can affect
Ynrl.www.minneapolisfed.org/research/prescott
This is an active area of research, and not just because Prescott
took home the Nobel Prize in 2004 for his contributions to “dynamic
macroeconomics: the time consistency of economic policy and the
driving forces behind business
cycles.”nobelprize.org/nobel_prizes/economics/laureates/2004/prescott-autobio.html
Other economists believe that activist policies designed to shift
AD to the right can influence Ynrl through a process
called hysteresis.economics.about.com/library/glossary/bldef-hysteresis.htm
It’s still all very confusing and complicated, so the author of
this book and numerous others prefer bringing an institutional
analysis to Ynrl, one that concentrates on providing
economic actors with incentives to labor, to develop and implement
new technologies, and to build new plant and infrastructure.
Stop and Think Box
People often believe that wars induce
long-term economic growth; however, they are quite wrong. Use
Figure 23.7 and the AS-AD model to explain why people think wars
induce growth and why they are wrong.
Y* often increases during wars because
AD shifts right because of increases in G (tanks, guns, ships,
etc.) and I (new or improved factories to produce tanks, guns,
ships, etc.) that exceed decreases in C (wartime rationing) and
possibly NX (trade level decreases and/or subsidies provided to or
by allies). Due to the right shift in AD, P* also rises, perhaps
giving the illusion of wealth. After the war, however, two things
occur: AD shifts back left as war production ceases and, to the
extent that the long run comes home to roost, AS shifts left. Both
lower Y* and the AD leftward shift decreases the price level.
Empirically, wars are indeed often followed by recessions and
deflation. Figure 23.7 shows what happened to prices and output in
the United States during and after the Civil War (1861–1865) and
World War I (1914–1918; direct U.S. involvement, 1917–1918),
respectively. The last bastion of the warmongers is the claim that,
by inducing technological development, wars cause Ynrl
to shift right. Wars do indeed speedresearch and
development, but getting a few new gizmos a few years sooner is not
worth the wartime destruction of great masses of human and physical
capital.
key takeaways
The ASL is the amount of output that is obtainable in the long
run given the available labor, technology, and physical capital
set.
It is vertical because it is insensitive to changes in the
price level.
Economists are not entirely certain why ASL shifts. Some point
to hysteresis, others to real business cycles, still others to
institutional improvements like the growth diamond.
Nobody knows how long the long term is, but the answer is
important for one’s attitude toward economic policymaking.
Those who favor activist policies think the long term is a long
way off indeed, so policymakers can benefit the economy by shifting
AD and AS to the right.
Those who are suspicious of interventionist policies think that
the long run will soon be upon us, so interventionist policies
cannot help the economy for long because output must soon return to
Ynrl.