Long Run Self Adjustment

3 Key excerpts on "Long Run Self Adjustment"

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  eBook - ePub

  Macroeconomics and Markets in Developing and Emerging Economies

  • Ashima Goyal(Author)
  • 2016(Publication Date)
  • Routledge India

    (Publisher)

  Short-run adjustment Monetary and fiscal policy

  She who can should do.

  8.1 Introduction

  So far, output was taken as given. In the long run, it is determined by technology, preferences and fully employed resources. But in the short run, if goods market prices are sticky, output must adjust to bring about equilibrium. Since goods prices do not adjust instantly to clear markets, aggregate demand determines output. In this chapter, we introduce the goods market. While output becomes endogenous, the price level is fixed in the short run.

  In an open economy with perfect capital mobility, however, the role of the exchange rate has to be taken into account even in short-run Keynesian analysis. The long run we have developed in the earlier chapters also affects the short run, since expectations of fundamental values affect short-run values of variables such as the exchange rate. These will, however, be affected by the many types of variables, discussed in the previous chapter, not only by the monetary variables. If forward-looking behaviour is modeled, it is necessary to distinguish between temporary and permanent changes. In the former expectations will not be affected and in the latter they would. The expected exchange rate, which was exogenous in our early analysis, now becomes endogenous.

  After briefly reviewing the mechanics of short-run output determination, we set up the canonical perfect capital mobility Mundell Fleming (MF) model and assess short-run stabilisation in the open economy. In the MF model, the relative effectiveness of monetary and fiscal policy depends on the exchange rate regime. But this assumes static expectations, so the effect of the long run on the short run is absent. If non-static expectations or some flexibility in prices are allowed, results are moderated.

  The MF model is a powerful benchmark for open economy macroeconomics, because of the clarity, symmetry and simplicity of its result. Therefore, its results, such as the impossible trinity – that autonomous monetary policy is not possible with a fixed exchange rate and perfect capital mobility – are well internalised and often quoted. But it is a simplification based on strict assumptions, and therefore almost never holds in the real world. The assumptions are systematically relaxed and their effects examined in this chapter. In addition to non-static expectations, we also examine FX market equilibrium under floating exchange rates, when some prices are flexible in the short run. This is the way a benchmark should be used rather than expecting to find it in the data. Alternatively, deviations from the benchmarks, often found in the data, set up puzzles to be explained.

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  eBook - ePub

  Reconstructing Keynesian Macroeconomics Volume 1

  Partial Perspectives

  • Carl Chiarella, Peter Flaschel, Willi Semmler(Authors)
  • 2012(Publication Date)
  • Routledge

    (Publisher)

  Figure 0.1 assumes that there is a fundamental causal nexus (or hierarchy) present in the interaction of the main markets of the macroeconomy which leads from the financial markets at the top of the hierarchy to the goods markets in the middle –based on the achieved valuation of the assets traded in the financial markets, the implied state of confidence and the term structure of interest rates – and from there to the labor markets at the bottom, which in turn depend on the effective demand that is realized in the market for goods. This viewpoint is fine from the perspective of dealing with short- and medium-run macroeconomic issues and problems, however we know that from the perspective of the long run (that is from the perspective of economic growth) that the labor market, productive knowledge and skills and productive potentials will play an important role in the long run performance of an economy. Or to state it even more succinctly, in the long run the supply side as well as the demand side are important.

  Figure 0.1 Advanced Keynesian disequilibrium growth dynamics: graphical summary of fairly sluggish or fairly fast, but never infinitely fast, feedback adjustment mechanisms.

  Furthermore, the dominance of the financial market in the interrelationship of the main markets of the macroeconomy does not operate in isolation, but is surrounded by feedback channels leading from lower level markets to higher level ones. A typical example is given by the famous Keynes-effect, according to which money wage decreases can revive the economy if they lead to price level decreases and therefore to increases in real balances of the household sector, which induces lower interest rates on the financial markets which in turn stimulate investment and thus effective goods demand, leading finally to increases in employment and thus to a check to further decreasing wages that is capable of moving the economy back to its full employment level. This intricate chain of events is in fact needed in Keynesian macroeconomics if the argument is made that adjusting money wages will lead the economy towards such full employment positions, often however being replaced by a grossly misleading short-cut, which looks only at the market and price for labor as the ones being responsible for its disease and which is subject to a confusion of nominal with real wages, when it recommends wage reductions. Keynes” (1936) argument here was that the policy advice of lowering nominal wages is in fact a very illusory one – based on a narrow and erroneous understanding of the working of the institutions in advanced capitalist market economies – since it represents a long and painful process, which indeed can be circumvented and abbreviated by the proper choice of monetary policy measures.

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  Macroeconomic Theory: A Short Course

  A Short Course

  • Thomas R. Michl(Author)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  overshoot its long-run equilibrium repeatedly. Overshooting is best understood through a physical analogy with a pendulum. If you start a pendulum away from its rest point, it will descend to the rest point and keep on going, thus overshooting its long-run equilibrium (the rest point). In the Phillips curve model, the lagged response of inflation expectations to actual inflation generates overshooting.

  10.6 Long-run equilibrium

  When we use the expression “long run” in economics, it means that the system is fully adjusted along some dimensions. In the Phillips curve model, the long-run is defined by attainment of the natural rate of unemployment and by equality between the inflation rate and the expected inflation rate. The term long-run is also used in other contexts in economics to describe an equilibrium in which the capital stock has had time to adjust fully to economic forces. Some writers have begun using the term “medium run” to describe the former state, devoting long-run to the latter.

  The long-run equilibrium in the Phillips curve occurs when the inflation and unemployment rates have converged on stable, constant values. We can easily solve for those values by substituting zeroes into the Phillips curve model in difference form. The solution is

  Δ u = 0

  Δ π = 0

  g Y

  = 0

  π =

  g m

  u =

  u n

  This is a long-run equilibrium because the system is fully adjusted in its two important dimensions. The inflation rate has settled down to the long-run value that generates no changes in the unemployment rate. The unemployment rate has settled down to the natural rate, at which the expected inflation rate equals the actual inflation rate. Thus, there are no further shifts in the Phillips curve caused by revisions in inflation expectations, or further changes in the unemployment rate, caused by changes in the real money supply. This characterization of the long run will become clearer in the next section.

  The long-run inflation rate is equal to the growth rate of the money supply. This illustrates the quantity theory of money (or if you prefer, the quantity of money theory of prices). Figure 10.4 shows that different choices by the central bank of monetary growth rates have no effect on the long-run unemployment rate, which remains the natural rate of unemployment. When money growth has no real effects on the economy—when it only affects the inflation rate—money is said to be superneutral The vertical long-run Phillips curve shown in Figure 10.4 illustrates the superneutrality of money. One implication of superneutrality is that any policy effort to lower the unemployment rate below its natural rate (i.e., force the economy to operate to the left of the long-run Phillips curve) can only be effective if the inflation rate is constantly rising. This is called the accelerationist hypothesis

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