ADAS and Phillips Curve

AD/SRAS overview Aggregate Demand Short Run Aggregate Supply Total spending on goods and services in the economy. A change in C, I, G, or Xn causes a change in AD PL and output (y) are changed by a change in AD Short Run Aggregate Supply Total amount of goods and services produced in the economy. A change in input prices, productivity and government policies change SRAS PL and output(y) are changed when SRAS changes.

Economic Conditions AD/AS at Full Employment Price Level LRAS SRAS AD YF PL AD/AS in Recession Y1 Price Level LRAS SRAS AD YF PL GDPR GDPR Price Level LRAS SRAS AD YF PL AD/AS with high inflation Y1 Price Level LRAS SRAS AD YF PL AD/AS with Stagflation Y1 GDPR GDPR

Changes in AD/SRAS… You tell me what changes and what happens to PL and output The government spends money national defense The price of oil rises There is a fall in consumer confidence Argentina buys more of US made goods The government increases regulation Interest rates increase Wages decrease Expansionary monetary policy The government gives subsidies to businesses ↑ AD, ↑ PL, ↑Y ↓ SRAS, ↑ PL, ↓ Y ↓ AD, ↓ PL, ↓Y ↑ AD, ↑ PL, ↑Y ↓ SRAS, ↑ PL, ↓ Y ↓ AD, ↓ PL, ↓Y ↑ SRAS, ↓PL, ↑ Y ↑ Sm, ↑ irN , ↑ AD, ↑ PL, ↑Y ↑ SRAS, ↓PL, ↑ Y

EFFECTS OF AD CHANGES? Relationship LRAS LRAS PL PL SRAS SRAS PL2 PL1 PL1 PL2 AD2 AD1 AD1 AD2 Y2 YF GDPR YF Y2 GDPR  AD ____ PL ____ Unemployment  AD ____ PL ____ Unemployment Trade-off! Relationship Between PL and Unemployment: (in the short run) Click the mouse once to fill in the blanks.

The Short Run Phillips Curve Key Idea: In the short run there is a TRADE-OFF between INFLATION and UNEMPLOYMENT. To reduce unemployment – inflation occurs To reduce inflation --- unemployment increases Research by a Kiwi (New Zealand) economist named Williams Phillips documented this relationship in 1958 by studying the UK from 1861-1958 . As a result a new model was developed to illustrate the trade-off: The Short Run Phillips Curve

The Short Run Phillips Curve Inflation Rate Inflation Rate %1 %2 %2 %1 SRPC SRPC U1 U2 Unemployment Rate U2 U1 Unemployment Rate  Inflation rate   unemployment rate  Inflation rate  ↓ unemployment rate Due to the trade-off (inverse relationship), what is the shape of the SRPC? Downward-sloping!

Goal Address the problem without creating a worse problem – limit the negative effects. When stagflation first occurred in the 1970s due to a supply-side shock (  price of oil/energy), it created a new dilemma for policymakers and called into question the credibility of the short run Phillips Curve (SRPC) relationship.

Stagflation: ???? LRAS PL SRAS2 Does stagflation negate the SRPC trade-off between inflation and unemployment? Some economists rejected the SRPC relationship; others found an alternative explanation. SRAS1 PL2 PL1 It appears to negate the inverse relationship. Both PL and unemployment increase! AD Y2 YF GDPR  SRAS  ____ PL ____ Unemployment

Stagflation and the SRPC Inflation Rate Inflation Rate % %2 SRPC2 SRPC2 %1 SRPC1 SRPC1 U Unemployment Rate U1 U2 Unemployment Rate Explanation: Stagflation simply caused the SRPC to shift to the right --- indicating that for each level of unemployment, there is a higher rate of inflation; for each inflation rate, there is a higher level of unemployment.

What about an increase in SRAS? LRAS PL Inflation Rate For each level of inflation, a lower level of unemploy- ment exists. SRAS1 SRAS2 Shift Left %1 %2 PL1 PL2 SRPC1 SRPC2 AD U Unemployment Rate YF Y2 GDPR For each level of unemployment, a lower level of inflation exists.  SRAS  ____ PL ____ Unemployment

Increase in AD → movement along Phillips Curve Price Level LRAS SRAS AD YF PL GDPR A Inflation Rate Unemployment LRPC SRPC %A NRU B %B PL2 AD2

Shift in SRAS→ Shift in SRPC Price Level LRAS SRAS AD YF PL GDPR A Inflation Rate Unemployment LRPC SRPC %A NRU B %B PL2 SRAS2 SRPC2

Practice Problems A short Run Phillips Curve shows an inverse relationship between Interest rates and borrowing Inflation and unemployment Income and consumption Prices and quantity demanded Inputs and outputs

Practice Problems Stagflation is most likely to be caused by An increase in AD A decrease in AD An increase in AS A decrease in AS A large increase in the money supply

Practice Problems An increase in personal income taxes will most likely cause AD and AS to change in which of the following ways in the short run? AD AS Not change Decrease Not change Increase Decrease Not Change Decrease Increase Increase Not Change

Practice Problems When firms restructure their operations to decrease production cost, the AS, PL and real output will change in which of the following ways? AS PL Output Shift left Increase Increase Shift left Increase No Change Shift right Increase Increase Shift right Decrease Increase Shift right Decrease Decrease

Practice Problems When an economy is at full employment, which of the following will most likely create demand pull inflation in the short run? Increase in the discount rate An increase in personal income taxes A decrease in the real rate of interest A decrease in government spending A decrease in the money supply

Practice Problems An increase in AD will cause which of the following? A movement along a given SRPC The LRPC to become horizontal An increase in the natural rate of unemployment A decrease in the capital stock A decrease in the expected price level

Practice Problems Which of the following would cause the SRAS to shift to the right? An increase in the age rate An increase in the interest rate An increase in the natural rate of unemployment A decrease in capital stock A decrease in the expected price level

Assume that the United States economy is currently in a recession in a short-run equilibrium. Draw a correctly labeled graph of the short-run and long-run Phillips curves. Use the letter A to label a point that could represent the current state of the economy in recession. (b) Draw a correctly labeled graph of aggregate demand and aggregate supply in the recession and show each of the following. The long-run equilibrium output, labeled Yf The current equilibrium output and price levels, labeled Ye and PLe, respectively To balance the federal budget, suppose that the government decides to raise income taxes while maintaining the current level of government spending. On the graph drawn in part (b), show the effect of the increase in taxes. Label the new equilibrium output and price levels Y2 and PL2, respectively. Assume that the Federal Reserve uses monetary policy to stimulate the economy. What open-market policy should the Federal Reserve implement? Using a correctly labeled graph of the money market, show how the policy in part (d)(i) affects nominal interest rates. What will be the impact of the policy on the price level? Explain. Now assume instead that the government and the Federal Reserve take no policy action in response to the recession. In the long run, will the short-run aggregate supply increase, decrease, or remain unchanged? Explain. In the long run, what will happen to the natural rate of unemployment?

The unemployment rate in the country of Southland is greater than the natural rate of unemployment. Using a correctly labeled graph of aggregate demand and aggregate supply, show the current equilibrium real gross domestic product, labeled YC, and price level in Southland, labeled PLC. The president of Southland is receiving advice from two economic advisers—Kohelis and Raymond—about how best to reduce unemployment in Southland. Kohelis advises the president to decrease personal income taxes. How would such a decrease in taxes affect aggregate demand? Explain. Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in taxes. Label the initial equilibrium from part (a) as point A, and the new equilibrium resulting from the decrease in taxes as point B. Raymond advises the president to take no policy action. What will happen to the short-run aggregate supply curve in the long run? Explain. Using a new correctly labeled graph of the short-run Phillips curve, show the effect of the change in the short-run aggregate supply you identified in part (c)(i).

Assume that a country’s economy is in equilibrium. Using a correctly labeled ADAS graph, show how an increase in the price of oil, an important resource will affect the price level and output in the short run. Using a correctly labeled graph, who how the increase in the price of oil affects the short run phillips curve. Assume that the central bank responds to the higher price of oil by increasing the money supply. Explain the process by which the increase in the money supply will affect the AD in the short run. Indicate how the increase in the money supply will affect real output and price level. Now assume instead of using monetary policy in response to the oil price increase, the government reduces business taxes, which result in lower production cost. Using a new correctly labeled graph, who the effect of the reduction in business taxes on the PL and output in the short run.