Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by Mehdi Arzandeh, University of Manitoba

© 2016 McGraw‐Hill Education Limited Long-Run Macroeconomic Adjustments 16 LEARNING OBJECTIVES LO16.1 Explain how the economy arrives at its long-run equilibrium. LO16.2 Explain how to apply the long-run AD–AS model to explain inflation, recessions, and growth. LO16.3 Explain the short-run trade-off between inflation and unemployment (the Phillips Curve). LO16.4 Discuss why there is no long-run trade-off between inflation and unemployment. LO16.5 Explain the relationship among tax rates, tax revenues, and aggregate supply. © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 16.1 From the Short Run to the Long Run Short-Run Aggregate Supply Input prices are inflexible aggregate supply curve is upwardly sloping Long-Run Aggregate Supply Input prices are fully flexible Vertical aggregate supply The transition LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 16.1 From the Short Run to the Long Run From the Short-Run AS to the Long-Run AS Production above potential output: High demand for inputs Input prices rise Short run aggregate supply shifts left Return to potential output Production below potential output Lower demand for inputs Input prices fall Short run aggregate supply shifts right LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 16-1 Short-Run and Long-Run Aggregate Supply Short-Run Aggregate Supply Long-Run Aggregate Supply AS1 ASLR AS2 AS1 a2 b1 a2 AS3 P2 P2 Price Level a1 Price Level a1 P1 P1 a3 a3 P3 P3 c1 GDP3 GDPf GDP2 GDPf Real Domestic Output, GDP Real Domestic Output, GDP LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 16-2 Equilibrium in the Long-Run AD-AS Model ASLR AS1 Price Level P1 a AD1 GDPf Real Domestic Output LO1 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Applying the Long-Run AD-AS Model 16.2 Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 16-3 Demand-Pull Inflation in the Long-Run AD-AS Model AS2 ASLR AS1 P3 c P2 b Price Level P1 a AD2 AD1 This graph demonstrates the effects of demand-pull inflation on the model. Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level. Since the demand-pull inflation causes the aggregate demand curve to shift to the right, it causes the price level to increase, which expands output to a higher level. Since the economy is now producing above the potential output, inputs are in high demand, which in the long run causes their prices to also adjust upwards. This therefore causes the short run aggregate supply curve to shift upwards, moving equilibrium back to the long run aggregate supply curve. In the short run, demand pull inflation increases both the price level and real output, but in the long run only the price level will increase as output will always return to the full-employment level. Qf Q2 Real Domestic Output LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Applying the Long-Run AD-AS Model 16.2 Demand-Pull Inflation In the short run, demand-pull inflation drives up prices and output In the long run, output is restored to GDPf and only the price level is higher LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Applying the Long-Run AD-AS Model 16.2 Cost-Push Inflation Cost-push inflation arises from factors that increase the cost of production at each price level LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 16-4 Cost-Push Inflation in the Long-Run AD-AS Model AS2 ASLR AS1 P3 c P2 b Price Level P1 a AD2 AD1 Under cost-push inflation, factors have arisen that have increased the cost of production at each level of production, causing the short run aggregate supply curve to shift upwards and increase the price level. Cost-push inflation typically causes inflationary pressures on the economy, and government usually will move to counter the negative effects by using fiscal and monetary policy to increase aggregate demand. This only ends up moving the prices even higher as the economy seeks to return to the natural full-employment level of output. If the government does not take action, the economy will eventually return on its own to the natural level, but the process will be painful as wide-spread business failures, layoffs, and plant closures usually follow the process. So the government ends up between a rock and a hard place: do nothing and deal with an extended recession, or take action and end up with higher inflation. Q2 Qf Real Gross Domestic Product, GDP LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Applying the Long-Run AD-AS Model 16.2 Cost-Push Inflation: Policy Dilemma If government attempts to maintain full employment, an inflationary spiral may occur Otherwise, the recession will linger, with high unemployment and a loss of real output LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 16-5 Recession in the Long-Run AD-AS Model ASLR AS1 AS2 P1 a P2 b Price Level P3 c AD1 AD2 The most challenging issue to deal with is the effect of recession on the model. In a recession, aggregate demand declines and shifts left, which reduces prices. The economy will be producing less, so the demand for inputs will be low. Eventually nominal wages will drop. Once the wages fall, aggregate supply will decrease, which will decrease prices further. We are back at the long run equilibrium of full-employment, but at a much lower price level. Q1 Qf Real Domestic Output LO2 © 2016 McGraw‐Hill Education Limited

Productions Possibilities Long Run Aggregate Supply Production Possibilities and Long-Run Aggregate Supply FIGURE 16-6 Productions Possibilities Long Run Aggregate Supply C 𝑨𝑺 𝑳𝑹𝟏 𝑨𝑺 𝑳𝑹𝟐 A Capital Goods Price Level Economic growth is illustrated by either an outward shift on the production possibilities curve or a rightward shift in the long run aggregate supply curve. As the curves shift, they will lead to price increases at a new equilibrium level. Prices very rarely decrease in the long run. Why not? The Federal Reserve will increase the money supply to create rightward shifts in the aggregate demand curve. B D 𝑮𝑫𝑷 𝟏 𝑮𝑫𝑷 𝟐 Consumer Goods Real GDP Increase in production possibilities Increase in long-run aggregate supply LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Applying the Long-Run AD-AS Model 16.2 Recession and the Long-Run AD-AS Model How long would it take in the real world for price and wage adjustments to occur to regain full employment? There is disagreement among economists LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Applying the Long-Run AD-AS Model 16.2 Ongoing Inflation in the Long-Run AD-AS Model Modern economies tend to experience positive rates of inflation due to Economic growth causing rightward shifts of the AS curve Central banks then cause rightward shifts of the AD curve so that it proceeds just a little faster than the deflationary rightward shifts of the AS curve The net effect is (usually) a small positive rate of inflation LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 Depicting Canadian Growth in the Long-Run AD-AS Model FIGURE 16-7 ASLR1 ASLR2 AS2 AS1 P2 Price level P1 AD2 The whole key to managing inflation is for the Bank of Canada to use monetary policy to shift the aggregate demand curve to the right faster than the supply factors of economic growth shift the long-run aggregate supply curve to the right. An economy can withstand mild inflation as long as it is occurring at a slow pace. It is the sudden shifts in the curve that cause economic chaos. AD1 Q1 Q2 Real GDP LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited Applying the Long-Run AD-AS Model 16.2 Long-Run AD-AS Model Economic growth causes increases in long-run aggregate supply Whether deflation, or inflation accompanies growth depends on the extent to which aggregate demand increases relative to aggregate supply Any inflation that occurs is the result of growth of aggregate demand It is not the result of the growth of real GDP LO2 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited The Inflation-Unemployment Relationship 16.3 Under normal circumstances, there is a short-run tradeoff between inflation & unemployment Aggregate supply shocks can cause both higher inflation and higher unemployment There is no significant tradeoff between inflation and unemployment over long periods of time LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 16-8 Phillips Curve: Concept and Canadian Empirical Data Empirical Data Data for the 1960s The Concept Annual Rate of Inflation (Percent) Unemployment Rate (Percent) Annual Rate of Inflation (Percent) . 68 . 69 . 67 . 66 . 65 . 64 . 63 . 62 . 61 Unemployment Rate (Percent) LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 The Short-Run Effect of Changes in Aggregate Demand on Real Output and the Price Level FIGURE 16-9 AS P3 Price Level P2 AD3 P1 AD2 P0 AD1 This idea is apparent here as we look at the short run aggregate supply curve illustrated in this graph. Here you can see that as aggregate demand expands, in the short run the price level increases. As the price level increases, firms will increase production, which in turn will lead to higher employment. We will end up with the downward sloping Phillips curve in the next slide. AD0 Q0 Q1 Q2 Q3 Real GDP LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited The Inflation-Unemployment Relationship 16.3 The Phillips Curve Modern economists reject the idea of a stable, predictable long-run Phillips Curve They agree there is a short-run tradeoff between inflation and unemployment LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited The Inflation-Unemployment Relationship 16.3 Aggregate Supply Shocks and the Phillips Curve In the late 1970s and early 1980s, the economy experienced stagflation LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited The Inflation-Unemployment Relationship 16.3 Adverse Aggregate Supply Shocks OPEC and Energy Prices Other shocks: Agricultural shortfalls Dollar depreciation Wage increases after wage-price controls lifted Declining productivity LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 Inflation Rates and Unemployment Rates in Canada, 1961-2014 FIGURE 16-10 Needs update? LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited The Inflation-Unemployment Relationship 16.3 Stagflation’s Demise By the late ‘80s, it appeared the Phillips curve had shifted back Recession of ‘81-’83 Increased foreign competition Deregulation of airlines and trucking Decline in OPEC’s power These factors also helped to reduce per-unit production costs and to shift the short-run AS curve rightward LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 16.1 GLOBAL PERSPECTIVE The Misery Index, Selected Nations, 2001-2012 This graph measures the effect of inflation and high unemployment on a nation’s mental health. Note that Canada is typically in the middle range. LO3 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 16.4 The Long-Run Phillips Curve There is no apparent long-run tradeoff between inflation and unemployment The Short-Run Phillips Curve Expectation and the Long-Run Vertical Phillips Curve Disinflation LO4 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 FIGURE 16-11 The Long-Run Vertical Phillips Curve PCLR 3 6 9 12 15 PC3 b3 PC2 a3 Annual Rate of Inflation (Percent) b2 PC1 a2 c3 b1 a1 c2 3 4 5 6 Unemployment Rate (Percent) LO4 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 16.5 Taxation and Aggregate Supply Taxes and Incentives to Work Government policies can impede or promote rightward shifts of AS Effects of taxation on the supply curve are key concerns of supply-side economics LO5 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 16.5 Taxation and Aggregate Supply Incentives to Save and Invest Lower marginal tax rates increase the rewards for saving and investing Saving is a prerequisite for investment LO5 © 2016 McGraw‐Hill Education Limited

Shows impact of tax rates LO4.1 FIGURE 16-12 The Laffer Curve Shows impact of tax rates upon tax collections 100 n Lower Tax Revenue Above m Tax rate (percent) m Maximum Tax Revenue l Tax revenue (dollars) LO5 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited 16.5 Taxation and Aggregate Supply Criticisms of the Laffer Curve Taxes, Incentives and Time Empirical evidence shows the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge Inflation or Real Interest Rates Demand side effects may be greater/quicker and certain Position on the Curve Rebuttal and Evaluation LO5 © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 The LAST WORD Do Tax Increases Reduce Real GDP? Determining the relationship between changes in taxes and permanent changes in real GDP is fraught with complexities and difficulties. University of California-Berkeley economists Christina Romer and David Romer have recently devised a novel way to approach the topic. Their findings suggest that tax increases reduce real GDP. On average, when economic activity rises more rapidly, tax revenues also are rising more rapidly Romer and Romer find that most tax changes are motivated by: counteracting other influences in the economy; paying for increases in government spending (or lowering taxes in conjunction with reductions in spending); addressing an inherited budget deficit; promoting long-run growth A tax increase of 1 percent of GDP lowers real GDP by roughly 2 to 3 percent. Romer and Romer find that tax increases to reduce an inherited budget deficit have much smaller output costs than other tax increases. © 2016 McGraw‐Hill Education Limited

© 2016 McGraw‐Hill Education Limited LO4.1 Chapter Summary LO16.1 Explain how the economy arrives at its long-run equilibrium. LO16.2 Explain in how to apply the long-run AD–AS model to explain inflation, recessions, and growth. LO16.3 Explain the short-run trade-off between inflation and unemployment (the Phillips Curve). LO16.4 Discuss why there is no long-run trade-off between inflation and unemployment. LO16.5 Explain the relationship among tax rates, tax revenues, and aggregate supply. © 2016 McGraw‐Hill Education Limited