From short to long run
The dynamics from the short to the long run
We shall describe how the synthesis explains the transition from the short run to the long run where the Keynesian model applies in the short term and the classic model in the long run.
Fig. 15.3:From short run to long run.
• Point A: We start at point A which is on LPC where the economy is in equilibrium. Say that expected inflation is 4% so we are also on the SPCt corresponding to an expected inflation of 4%. Since we are in equilibrium, inflation and the growth of the money supply is equal to wage inflation and these must be equal to expected inflation. In point A we therefore have
n = K„, = n = 71e = 4%.
• Movement 1: Suppose that nM suddenly and unexpectedly rises to 6%. The AD curve will then glide upward faster than the AS curve and Y will increase and n will increase. When Y increases, L increases and U will fall. Since the increase is not expected, inflation expectations will not change and neither will SPC. We move up along SPC 1 and nW increases. According to the discussion in section X, n and nW will eventually increase until they reach 6% and we move up to point B. So far, the discussion is completely consistent with the Keynesian model (as we have not replaced the SPC).
• SPC1 — SPC2: As inflation is 6% at point B, inflation expectations must eventually increase. If inflation was 4% for a long time and it rises to and stabilizes at 6%, it is reasonable to expect future inflation to be 6%. In the synthesis, SPC shifts upwards to SPC2 which applies to
ne = 6%.
• Point B: When inflation expectations have become 6%, we are below the new short-run Phillips curve. When the economy is at point B with unemployment below the natural rate, wages will rise by more than 6%. From SPC2 we can conclude that a wage inflation of 8% is consistent with an expected inflation of 6% when unemployment is equal to UB.
• Movement 2: If wages, and therefore prices, rises by more than 6%, the AS curve will glide upwards faster than the AD curve which means that Y will fall and U will increase. This must continue until we reach point C, where we once again are in equilibrium.
Note that in the Keynesian model SPCt is the only Phillips curve and it is valid in the long run as well. In this model, there is no "movement 2". The economy may remain in point B with n = nw = nM = 6% if this is desired by the government. The economy may return to point A by using restrictive fiscal and monetary policy.
In this section, inflation expectations did not change until we reached point B. This choice was more of a pedagogical choice to isolate and study each event individually. In reality, it is more likely that inflation expectations will slowly increase as we begin to move from point A to point B as inflation increases in this move. We would then have a movement from A to C more similar to movement 3 in the figure below. If the change in nM was announced prior to the actual change, it is possible that ne immediately changed to 6% at point A. We would then see the movement 4 directly from A to C (which, however, may take some time because of wage contracts).
Fig. 15.4: From short to long run with a faster change in inflation expectations.
From the neo-classical synthesis, another important conclusion may be drawn. In order to keep U below UN, you need an accelerating inflation. Suppose that full employment is compatible with 4% inflation in the long run. In the Keynesian model, we can keep U below UN if we accept that inflation is above 4%. An inflation of, for example 7%, would keep the U below UN indefinitely. In the neo-classical synthesis, this will not work. If we want to keep U below UN, we must accept an ever higher inflation. In order to keep U one percentage unit below UN we might need an inflation of 7% in the first period, 9% in the second period, then 13% and so on.
Figure 15.3 will explain why. In order to reduce unemployment below UN, the growth rate in money supply must increase (unexpectedly). If nothing else is done, U will fall back to UN (now with a higher inflation). In order to keep U below UN, nM must increase again and again at an accelerating rate.
Only the natural rate of unemployment, UN, is compatible with a non-accelerating inflation and this rate is therefore often called the NAIRU (Non-Accelerating Inflation Rate of Unemployment).