Chapter 3

The Short Run and the Long Run


Understanding actual and potential GDP

Examining the short-run long-run distinction

Recognizing the benefits of a unified model

Considering long-run policy commitments and short-run policy flexibility

A modern economy produces and distributes a vast array of goods and services: cars, appliances, education, health services, sports equipment, and much more. In many if not most economies, the bulk of this activity is organized through a market mechanism, which is surprising really because you can’t see it or touch it.

As Adam Smith noted over 200 years ago, the market works like “an invisible hand” to guide a multitude of economic endeavors that result in consumers getting the goods they want at a reasonably low cost. For example, no one is directing all the people involved in getting bread to consumers (the flour producer, the baker, the delivery driver, the shopkeeper, and so on). No one needs to tell them what to make or when and where to trade — they just do it. Each producer is trying to do the best for herself, of course. Yet amazingly, their efforts end up doing well for everyone — all the bread-lovers get the fresh, tasty loaves they want while all the farmers, millers, and bakers get paid. Contrast that with the command-and-control bread production of the old Soviet Union where bread shelves were empty half of the time.

Similarly, it’s a safe bet that very few individuals have the knowledge and ability to create ...

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