Unit 2: Aggregate Demand and Supply and Fiscal Policy 1

Achieving the Three Goals The governments role is to prevent unemployment and prevent inflation at the same time. If the government focuses too much on preventing inflation and slows down the economy we will have unemployment. If the government focuses too much on limiting unemployment and overheats the economy we will have inflation   Unemployment Inflation GDP Growth Good 6% or less 1%-4% 2.5%-5% Worry 6.5%-8% 5%-8% 1%-2% Bad 8.5 % or more 9% or more .5% or less

The Phillips Curve Shows tradeoff between inflation and unemployment. What happens to inflation and unemployment when AD increase?

In general, there is an inverse relationship between unemployment and inflation 4

The Phillips Curve The lower the unemployment rate, the tighter the labor market and, therefore, the faster firms must raise wages to attract scarce labor. At higher rates of unemployment, the pressure is abated. 

Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation When there is a recession, unemployment is high but inflation is low 5% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% SRPC 2% 9% Unemployment 6

Short Run Phillips Curve What happens when AS falls causing stagflation? Increase in unemployment and inflation Inflation 5% SRPC1 1% SRPC 2% 9% Unemployment 7

Short Run vs. Long Run Change in Inflationary Expectations If an increase in AD leads people to expect higher prices in the future. This increases labor and resource costs and decreases AS. Workers will negotiate a higher wage if everyone expects inflation. An increase in expected inflation shifts the short-run Phillips curve upward. The actual rate of inflation at any given unemployment rate is higher when the expected inflation rate is higher.

Short Run vs. Long Run What happens when AD increases? What happens in the long run? Long Run Phillips Curve Inflation In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 5% 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment SRPC1 1% SRPC 2% 5% 9% Unemployment 9

Short Run vs. Long Run Long Run Phillips Curve In the long run there is no tradeoff between inflation and unemployment Long Run Phillips Curve Inflation 5% The LRPC is vertical at the Natural Rate of Unemployment 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9% Unemployment 10

What happens when AD falls? What happens in the long run? Short Run vs. Long Run What happens when AD falls? What happens in the long run? Long Run Phillips Curve Inflation 5% In the long run wages fall and there is no tradeoff between inflation and unemployment 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% SRPC SRPC1 2% 5% 9% Unemployment 11

AD/AS and the Phillips Curve

AD/AS and the Phillips Curve Show what happens on both graphs if AD increase LRPC Price Level LRAS Inflation AS PLe AD1 AD SRPC QY GDPR UY Unemployment 15

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls? Price Level LRAS LRPC Inflation AS PLe AD SRPC AD1 QY GDPR UY Unemployment 16

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC at full employment. What happens when AS falls? Price Level LRAS LRPC Inflation AS1 AS PLe SRPC1 AD SRPC QY GDPR UY Unemployment 17

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up? Price Level LRAS LRPC Inflation AS AS1 PLe SRPC AD SRPC1 QY GDPR UY Unemployment 18

SRAS LRPC LRAS Price Level Inflation SRPC QY GDPR UY Unemployment 19

SRAS LRPC LRAS Price Level Inflation PLe AD2 AD SRPC AD3 QY GDPR UY Unemployment 20

AS1 SRAS LRPC LRAS Price Level Inflation AS2 PLe SRPC1 AD SRPC2 SRPC QY GDPR UY Unemployment 21

Short Run to Long Run AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPR UY Unemployment 22

AD/AS and the Phillips Curve Rational Expectations Individuals make decisions using all available information: including past inflation rates, and current government actions (monetary and fiscal policy)

Short Run to Long Run Problem with the Phillips Curve: (Rational Expectations) Government short-run trade-off of higher inflation for lower unemployment rates Workers negotiate long term wage contracts that reflect future inflation rates. (government policy fails in the long-run) AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPR UY Unemployment 24

Analyzing the Economy Graphically 26

PPC Business Cycle AD/AS Phillips Curve Use the following models to show full employment, a recessionary gap, and an inflationary gap. PPC Business Cycle AD/AS Phillips Curve 27

The Good, the Bad, and the Ugly   Unemployment Inflation GDP Growth Good 6% or less 1%-4% 2.5%-5% Worry 6.5%-8% 5%-8% 1%-2% Bad 8.5 % or more 9% or more .5% or less 28

Phillip’s Curve Practice What does the SRPC show? What does the LRPC demonstrate, explain WHY. What does an increase in aggregate demand show on the Phillip’s curve? What does a decrease in aggregate demand show on the Phillip’s curve? What happens on the Phillip’s curve when the aggregate supply curve shifts (be specific) What impact does inflationary expectations have on government spending? Name 10 cartoon characters.