AS/AD, the Multiplier, the Phillips Curve Chapters 10 and 8

Aggregate Demand Aggregate Demand (AD) Curve that shows the amount of real output (Real GDP) that buyers collectively desire to purchase at each possible price level Demand for all goods combined (aggregate)

AD cont. Downward sloping curve Not for the same reasons as demand (income and substitution effects) Real-balances effect Increases in PL erode savings and make people less likely to purchase things Interest-rate effect High prices raise interest rates and make it more difficult to get loans to make purchases or invest in a business Foreign purchases effect High domestic prices make it more likely that Americans will buy foreign products and foreigners will not buy American products

AD cont. Movement along a curve PL changes lead to movements along the AD curve

AD cont. Changes in determinants of AD lead to shifts. C + I + G + Xn If any increase without a change in PL, AD shifts Consumer spending Real consumer wealth Stocks, bonds, housing, land Consumer expectations Expect wealth to increase or expect inflation Household debt Increases in debt raise AD Taxes Reducing personal income taxes raises AD Demand-side Policies Interest rates Make it cheaper or more expensive to borrow money to consume

AD cont. Changes cont. Investment spending The Demand of investment comes from the expected returns of investment Future business conditions Technology Excess capacity Increases lead to reduced expected returns Business taxes Increase taxes lowers expected returns Interest rates Effect of real interest rates Increase in real interest rates reduces investment spending

AD cont. Changes cont. Government Spending Net exports All increases in spending (transfer payments or goods and services) will raise AD as long as tax or interest rates do not change Net exports Rising national income abroad raises AD Tastes for American goods Exchange rates Depreciating currency raises AD Makes American goods cheaper Makes foreign goods expensive

Aggregate Supply Aggregate Supply (AS) Level of real domestic output producers will produce at a given price level Short Run VS Long Run SRAS is when input prices (usually nominal wage) do not match price level changes LRAS is when input prices (usually nominal wages) do match price level changes

AS cont. SRAS Input prices like nominal wages do not immediately adjust to inflation Sticky wages and prices theories Say prices double. Will profit increase in the short run? Why or why not? Profit will increase, leading to greater output by firms. Thus, the curve is upward sloping. Per-unit production cost=(total input cost)/(units of output) Per unit costs rise as output expands, but the rate of increase rises as output gets closer to LRAS and then goes past it. Thus, the SRAS curve gets more vertical Think about what this means on a PPC

AS cont. Shape of SRAS Curve Horizontal Vertical High unemployment Price level and wages change slowly with output Vertical Low unemployment Nominal wages adjust more quickly to changes in price level

AS cont. Changes in SRAS Anything that makes it harder or more expensive for businesses to produce causes SRAS to decrease and anything that makes it easier or less expensive to produce causes SRAS to increase. Producer expectations about price Same effects as their impacts on Supply Input price changes Domestic (land and labor) or international resources Market or Monopoly power (OPEC) of sellers Positive or Negative Supply Shocks Legal-institutional environment Business taxes and subsidies “Supply-side” Economics Business taxes change AD AND SRAS! Regulation Productivity

AS cont. LRAS As inflation occurs input prices and wages adjust, but it takes time Thus, it is a long run change Say prices double, will profit increase in the long run? Why or why not?

AS cont. Price does not affect output in the long run, so the LRAS curve is vertical at potential output for the economy Think about what this means on a PPC

AS cont. Changes in LRAS and SRAS Economic Growth leads to increases in LRAS and PPC Availability of resources Increases in capital stock due to increased investment in the long run Policy incentives Policies that provide incentives to quickly find a job or invest in capital or technology Changes in the labor force participation rate Productivity and Technology Productivity=(total output)/(total input) Increase in productivity leads to decrease in per-unit costs Net Investment Negative causes negative growth while positive causes positive growth If capital depreciates faster than new investment occurs, then capital becomes less productive

Shifts and Equilibrium Intersection point Price Level Real output Both change with changes in SRAS, LRAS, or AD Long-Run Equilibrium When SRAS, LRAS, AD are in equilibrium

Long-Run Equilibrium Price Level Short-run aggregate supply, AS demand, AD A P Y Quantity of Output Copyright © 2004 South-Western

Shifts and Equilibrium cont. When SRAS and AD are not in equilibrium with LRAS, a recessionary gap or inflationary gap occur. Difference between potential and actual output Recessionary Gap SRAS/AD equilibrium is the left of LRAS PPC Graph? Economy is operating below full capacity Unemployment is above NRU Inflationary Gap SRAS/AD equilibrium is the right of LRAS Economy is operating above full capacity Unemployment is less than NRU

AS/AD cont. Increase in AD Decrease in AD Demand-pull inflation If we are at pull employment and businesses/governments/households increasing spending or invest AD shifts and causes PL to rise Decrease in AD Recession and unemployment GDP decreases and inflation decreases

AS/AD cont. Increase in AS Decrease in AS Increases in output and stability in prices The best of all possible scenarios! 1990s Decrease in AS Cost-push inflation Stagflation

A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run . . . Price Level Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AS2 AD2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 4. . . . and output returns to its natural rate. Quantity of Output Copyright © 2004 South-Western

Savings/DI/Consumption Gross income is income before taxes and disposable income is income after taxes. Disposable Income = Consumption + Savings Income has the biggest impact on savings As all incomes rise, we expect total consumption to increase. Dissaving Spending more than income after taxes Liquidate assets or borrow Break-even income Income at which households plan to consume their entire incomes

APC/APS Average Propensity to Consume (APC) APC = (consumption) / (income) Percentage of total income consumed Average Propensity to Save (APS) APS = (saving) / (income) Percentage of total income saved APC + APS = 1

MPC/MPS Just because we save or consume at a certain level now does not guarantee we will consume/save at the same level if income increases or decreases in the future Marginal Propensity to Consume (MPC) Tells us how much more you will consume if you earn an additional dollar MPC = (Change in consumption) / (Change in income) Falls as individuals become wealthier. Why? Marginal Propensity to Save (MPS) Tells us how much you will save if you earn an additional dollar MPS = (change in saving) / (change in income) Rises as individuals become wealthier. Why? MPC + MPS = 1

Changes in Consumption and Saving DI changes consumption and savings, but other things can also change it Wealth Effect People see increases in their wealth (home prices rising, stocks and bonds rising) so they spend more Expectations about recessions and expansions Real Interest Rates Household Debt Changes consumption and savings in opposite directions Taxation Lowers both

The Multiplier Effect Spending has a multiplier effect on the economy because consumption increases as income increases. In other words, one person’s consumption becomes another’s income. There’s a multiplier effect! Spending Multiplier = 1 / (1 – MPC) AKA expenditures multiplier OR Simple Spending Multiplier Tells us how any change spending (government, investment, exports, consumption) can ultimately change AD and GDP. Taxing Multiplier = -MPC / (1-MPC) Which is bigger, spending or taxing? MPC determines the size of the multipliers!

Unemployment and Inflation Society faces a short-run tradeoff between unemployment and inflation. If aggregate demand expands, it can cause lower unemployment, but only at the cost of higher inflation. If aggregate demand contracts, it can cause lower inflation, but at the cost of temporarily higher unemployment.

THE PHILLIPS CURVE The Phillips curve illustrates the short-run relationship between inflation and unemployment.

The Phillips Curve Inflation Rate (percent Phillips curve per year) 4 B 6 7 A 2 Unemployment Rate (percent) Copyright © 2004 South-Western

Aggregate Demand, Aggregate Supply, and the Phillips Curve The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

Aggregate Demand, Aggregate Supply, and the Phillips Curve The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. A higher level of output results in a lower level of unemployment.

How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve Price Inflation Level Short-run aggregate supply High aggregate demand Rate (percent Phillips curve per year) Low aggregate demand (output is 8,000) B 4 6 8,000 (unemployment is 4%) 106 B (unemployment is 7%) 7,500 102 A (output is 7,500) A 7 2 Quantity Unemployment of Output Rate (percent) Copyright © 2004 South-Western

The Long-Run Phillips Curve In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

The Long-Run Phillips Curve Inflation Rate Long-run Phillips curve B High inflation 1. When AD Increases, the rate of inflation Increases… 2. . . . but unemployment remains at its natural rate in the long run. Low inflation A Natural rate of Unemployment unemployment Rate Copyright © 2004 South-Western

How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve Price Long-run aggregate Inflation Long-run Phillips Level Rate supply curve 1. An increase in aggregate demand 3. . . . and increases the inflation rate . . . AD2 P2 B B 2. . . . raises the price level . . . A P A Aggregate demand, AD Natural rate Quantity Natural rate of Unemployment of output of Output unemployment Rate 4. . . . but leaves output and unemployment at their natural rates. Copyright © 2004 South-Western

Expectations and the Short-Run Phillips Curve Expected inflation measures how much people expect the overall price level to change. In the long run, expected inflation adjusts to changes in actual inflation. (Think SRAS shifting to get us back to Long Run Equilibrium)

How Expected Inflation Shifts the Short-Run Phillips Curve 2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. Inflation Rate Long-run Short-run Phillips curve with high expected inflation Phillips curve C Short-run Phillips curve with low expected inflation B 1. Increase in AD moves the economy up along the short-run Phillips curve . . . A Natural rate of Unemployment unemployment Rate Copyright © 2004 South-Western

The Natural Experiment for the Natural-Rate Hypothesis The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis. Historical observations support the natural-rate hypothesis.

The Natural Experiment for the Natural Rate Hypothesis The concept of a stable Phillips curve broke down in the in the early ’70s. Stagflation During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.

The Phillips Curve in the 1960s Inflation Rate (percent per year) 10 8 6 1968 4 1966 1967 2 1965 1962 1964 1961 1963 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Breakdown of the Phillips Curve Inflation Rate (percent per year) 10 8 6 1973 1970 1971 1969 4 1968 1972 1966 1967 2 1965 1962 1964 1961 1963 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS The short-run Phillips curve can shift due to changes in expectations. The short-run Phillips curve also shifts because of shocks to aggregate supply. Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge. This shifts the economy’s aggregate supply curve. . . . . . and as a result, the Phillips curve.

An Adverse Shock to Aggregate Supply (a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve Price Inflation 4. . . . giving policymakers a less favorable tradeoff between unemployment and inflation. Level AS2 Rate Aggregate PC2 B supply, AS 1. An adverse shift in aggregate supply . . . B P2 Y2 3. . . . and raises the price level . . . P A Y A Aggregate demand Phillips curve, P C Quantity Unemployment 2. . . . lowers output . . . of Output Rate Copyright © 2004 South-Western

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum. Fight the unemployment battle by expanding aggregate demand and accelerate inflation. Fight inflation by contracting aggregate demand and endure even higher unemployment.

The Supply Shocks of the 1970s Inflation Rate (percent per year) 10 1981 1980 1975 1974 1979 8 1978 6 1977 1976 1973 4 1972 2 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

THE COST OF REDUCING INFLATION To reduce inflation, AD would need to shift to the left. This leads to a rise in unemployment.

Disinflationary Monetary Policy in the Short Run and the Long Run 1. A decrease in AD moves the economy down along the short-run Phillips curve . . . Inflation Long-run Rate Phillips curve Short-run Phillips curve with high expected inflation A Short-run Phillips curve with low expected inflation C B 2. . . . but in the long run, expected inflation falls, and the short-run Phillips curve shifts to the left. Natural rate of Unemployment unemployment Rate Copyright © 2004 South-Western

THE COST OF REDUCING INFLATION To reduce inflation, an economy must endure a period of high unemployment and low output. The economy experiences lower inflation but at the cost of higher unemployment.