26 Supply-Side Equilibrium: Unemployment and Inflation? We might as well reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by [demand] or [supply]. ALFRED MARSHALL Supply-Side Equilibrium: Unemployment and Inflation? We might as well reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by [demand] or [supply]. ALFRED MARSHALL

●The Aggregate Supply Curve ●Equilibrium of Aggregate Demand and Supply ●Recessionary and Inflationary Gaps Revisited ●Adjusting to a Recessionary Gap: Deflation or Unemployment? ●The Aggregate Supply Curve ●Equilibrium of Aggregate Demand and Supply ●Recessionary and Inflationary Gaps Revisited ●Adjusting to a Recessionary Gap: Deflation or Unemployment? Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

●Adjusting to an Inflationary Gap: Inflation ●Stagflation from a Supply Shock ●Inflation and the Multiplier ●A Role for Stabilization Policy ●Adjusting to an Inflationary Gap: Inflation ●Stagflation from a Supply Shock ●Inflation and the Multiplier ●A Role for Stabilization Policy Contents (continued) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Aggregate Supply Curve ●The aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied, holding all other determinants of quantity supplied constant.

FIGURE 26-1 An Aggregate Supply Curve Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Level Real GDP S S

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Aggregate Supply Curve ●Why the Aggregate Supply Curve Slopes Upward ♦Firms normally can purchase labor and other inputs at prices that are fixed for some period of time. ♦Higher prices, thus, mean higher profits and more incentive to produce. ●Why the Aggregate Supply Curve Slopes Upward ♦Firms normally can purchase labor and other inputs at prices that are fixed for some period of time. ♦Higher prices, thus, mean higher profits and more incentive to produce.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Aggregate Supply Curve ●Shifts of the Aggregate Supply Curve ♦Costs of production are constant along the AS curve. ♦  costs of production  shifts in the AS curve ■The money wage rate ■Prices of other inputs ■Technology and productivity ■Available supplies of labor and capital ●Shifts of the Aggregate Supply Curve ♦Costs of production are constant along the AS curve. ♦  costs of production  shifts in the AS curve ■The money wage rate ■Prices of other inputs ■Technology and productivity ■Available supplies of labor and capital

FIGURE 26-2 A Shift of the Aggregate Supply Curve Copyright © 2003 South-Western/Thomson Learning. All rights reserved. S 1 S 1 (higher wages) S 0 S 0 (lower wages) 100 6,000 Price Level 5,500 Real GDP AB

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Aggregate Supply Curve ●Shifts of the Aggregate Supply Curve ♦  cost of production  inward shift of AS curve ■Money wage rate ■Interest rate ■Materials prices ●Shifts of the Aggregate Supply Curve ♦  cost of production  inward shift of AS curve ■Money wage rate ■Interest rate ■Materials prices

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Shifts of the Aggregate Supply Curve ♦  costs of production  outward shift of AS curve ■Improvements in technology ■Increases in productivity ■Increases in supplies of labor and capital ●Shifts of the Aggregate Supply Curve ♦  costs of production  outward shift of AS curve ■Improvements in technology ■Increases in productivity ■Increases in supplies of labor and capital The Aggregate Supply Curve

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Equilibrium of Aggregate Demand and Supply ●Price level adjustments  AS-AD equilibrium ●Imbalance between AS and AD   inventories   price   quantity of AS and AD ●Price level adjustments  AS-AD equilibrium ●Imbalance between AS and AD   inventories   price   quantity of AS and AD

FIGURE 26-3 Equilibrium of Real GDP and the Price Level Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Level D D S S 100 6,4006,8005,2005,6006,000 Real GDP E

TABLE 26-1 Determination of the Equilibrium Price Level Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Short run: AS-AD equilibrium may or may not equal full employment GDP ♦Recessionary gap: Equilibrium GDP < Potential GDP ♦Inflationary gap: Equilibrium GDP > Potential GDP ●Short run: AS-AD equilibrium may or may not equal full employment GDP ♦Recessionary gap: Equilibrium GDP < Potential GDP ♦Inflationary gap: Equilibrium GDP > Potential GDP Recessionary and Inflationary Gaps Revisited

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Recessionary and Inflationary Gaps Revisited ●Long-run: market forces make equilibrium GDP = potential GDP

FIGURE 26-5 The Elimination of a Recessionary Gap Copyright © 2003 South-Western/Thomson Learning. All rights reserved ,000 Recessionary gap S 0 S 0 D D Potential GDP Price Level 6,000 Real GDP E S 1 S 1 F B

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ●When unemployment exists, if money wages fall: ♦The aggregate supply curve will shift outward ♦Full employment will be attained eventually ●When unemployment exists, if money wages fall: ♦The aggregate supply curve will shift outward ♦Full employment will be attained eventually

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●In the real economy, however, wage reductions are slow and uncertain, particularly in the post-World War II period. Adjusting to a Recessionary Gap

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ●There are several possible reasons why wages are so sticky in the downward direction: ♦Institutional rigidities ♦Psychological resistance ♦Reduced severity of business cycles ♦Competition for the best workers ●There are several possible reasons why wages are so sticky in the downward direction: ♦Institutional rigidities ♦Psychological resistance ♦Reduced severity of business cycles ♦Competition for the best workers

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ●With sticky wages, cyclical unemployment may last a long time.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ●Does the Economy Have a Self-Correcting Mechanism? ♦The economy will self-adjust eventually. ■  wages   demand for labor ■  prices   demand for goods and services ♦But many people believe that government intervention should help to speed the process. ●Does the Economy Have a Self-Correcting Mechanism? ♦The economy will self-adjust eventually. ■  wages   demand for labor ■  prices   demand for goods and services ♦But many people believe that government intervention should help to speed the process.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ●An Example from Recent History: Disinflation in Japan the 1990s ♦Recovery from the recession was weak and long delayed, but it did eventually come. ♦Practical question: How long can we afford to wait? ●An Example from Recent History: Disinflation in Japan the 1990s ♦Recovery from the recession was weak and long delayed, but it did eventually come. ♦Practical question: How long can we afford to wait?

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ●When GDP > full employment ♦Price level rises ♦Labor is in short supply ●Both forces   money wages ♦AS curve shifts inward ♦Employment falls ♦Eventually eliminates the inflationary gap ●When GDP > full employment ♦Price level rises ♦Labor is in short supply ●Both forces   money wages ♦AS curve shifts inward ♦Employment falls ♦Eventually eliminates the inflationary gap

FIGURE 26-6 The Elimination of an Inflationary Gap Copyright © 2003 South-Western/Thomson Learning. All rights reserved. S 1 S 1 S 0 S 0 D D Real GDP Price Level E Inflationary gap Potential GDP F B

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ●During this process, both prices and unemployment are increasing. ●Stagflation = inflation that occurs while the economy is growing slowly or having a recession ●During this process, both prices and unemployment are increasing. ●Stagflation = inflation that occurs while the economy is growing slowly or having a recession

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ●Demand Inflation and Stagflation ♦In an inflationary gap, prices and wages rise because of excess demand. ♦Rising wages are a symptom, not a cause, of the underlying problem. ♦A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand. ●Demand Inflation and Stagflation ♦In an inflationary gap, prices and wages rise because of excess demand. ♦Rising wages are a symptom, not a cause, of the underlying problem. ♦A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ●The stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ●The U.S. economy has experienced two episodes of stagflation in the last decade. ♦The more notable one came between 1988 and 1990 – low unemployment was accompanied by moderate inflation. ♦A milder version of this same phenomenon occurred in the first half of 1999; however, inflation was generally held in check. ●The U.S. economy has experienced two episodes of stagflation in the last decade. ♦The more notable one came between 1988 and 1990 – low unemployment was accompanied by moderate inflation. ♦A milder version of this same phenomenon occurred in the first half of 1999; however, inflation was generally held in check.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Stagflation from a Supply Shock ●Independent shifts inward in aggregate supply are a second cause of stagflation. ●The increase in world oil prices caused such a shift twice in the 1970s. ●Favorable supply shocks tend to push output up and reduce inflation. ●Independent shifts inward in aggregate supply are a second cause of stagflation. ●The increase in world oil prices caused such a shift twice in the 1970s. ●Favorable supply shocks tend to push output up and reduce inflation.

FIGURE 26-7 Stagflation from an Advance Shift in AS Copyright © 2003 South-Western/Thomson Learning. All rights reserved ,099 Price Level (1996 = 100) 4,123 Real GDP D D S 1 S 1 S 0 S 0 A E

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Inflation   size of the multiplier ●As long as the aggregate supply curve is upward sloping,  AD   price level ●This, in turn, drains off some of the higher real demand. ♦  purchasing power of consumer wealth ♦  net exports ●Inflation   size of the multiplier ●As long as the aggregate supply curve is upward sloping,  AD   price level ●This, in turn, drains off some of the higher real demand. ♦  purchasing power of consumer wealth ♦  net exports Inflation and the Multiplier

FIGURE 26-8 Inflation and the Multiplier Copyright © 2003 South-Western/Thomson Learning. All rights reserved. S S $800 billion D 1 D 1 6, ,600 A D 0 D 0 Price Level 6,800 Real GDP E 0 E 1

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Since the economy’s self-correcting mechanism sometimes works slowly, there is room for government stabilization policy to improve the workings of the free market. A Role for Stabilization Policy