© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 1 SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE Long-Run Macroeconomic Adjustments

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 2 In this chapter you will learn 14.1 To apply the long-run AD-AS model to explain inflation, recessions, and unemployment 14.2 About the inflation- unemployment relationship 14.3 The long-run Phillips Curve 14.4 About the effects of taxation on aggregate supply

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 3 Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 4 Applying the Long-Run AD- AS Model q Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level

Price Level Real domestic product o AS 1 Demand-Pull Inflation P1P1 GDP f The starting point is full employment GDP (GDP f ) AD 1 Figure 14-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 5

o AS 1 P1P1 Something causes AD to increase… what are some possibilities? AD 1 Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 6

o AS 1 P1P1 Higher demand leads to a higher price level, and higher output AD 1 P2P2 AD 2 GDP 2 Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 7

o AS 1 P1P1 AD 1 P2P2 AD 2 GDP 2 A higher price level (P 2 ) EVENTUALLY leads to higher nominal wages which causes.... Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 8

o AS 1 P1P1 P3P3 GDP 2 AD 2 A left shift of the short run AS curve AS 2 P2P2 AD 1 Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 9

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Demand-Pull Inflation q in the short run, demand-pull inflation drives up prices and output q in the long run, output is restored to GDP f and only the price level is higher

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Cost-Push Inflation q Cost-push inflation arises from factors that increase the cost of production at each price level

o AS 1 P1P1 GDP f Something drives up production costs…such as? AD 1 Cost-Push Inflation Figure 14-2 Price Level AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 12

o AS 1 P1P1 AS shifts to the left, leading to higher prices and lower output AD 1 AS 2 P2P2 Price Level Cost-Push Inflation Figure 14-2 GDP 2 GDP f AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 13

o AS 1 P1P1 Now what? Left alone, the economy will eventually make its way back to GDP f AD 1 AS 2 P2P2 HOW? Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 14

o AS 1 P1P1 Layoffs, high unemployment will eventually lead to lower factor prices AD 1 AS 2 P2P2 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 15

o AS 1 P1P1 What other options are there? AD 1 AS 2 P2P2 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 16

o AS 1 P1P1 Expansionary fiscal or monetary policy AD 1 AS 2 P2P2 AD 2 P3P3 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 17

o AS 1 P1P1 But this leads to higher inflation AD 1 AS 2 P2P2 AD 2 P3P3 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 18

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Cost-Push Inflation q if government attempts to maintain full employment, an inflationary spiral may occur q otherwise, there will be a recession, with high unemployment and a loss of output

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Recession & the Long-Run AD-AS Model q how long would it take in the real world for price & wage adjustments to occur, to regain full employment? q there is disagreement among economists about how long

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Inflation-Unemployment Relationship q Under normal circumstances, there is a short-run tradeoff between inflation & unemployment q Aggregate supply shocks can cause both higher inflation & higher unemployment q There is no significant tradeoff between inflation & unemployment over long periods of time

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Phillips Curve q Assuming a constant AS, high rates of inflation are accompanied by low rates of unemployment, & vice-versa illustrated…

o P0P0 GDP 0 AS AD 0 The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 24

o P0P0 P1P1 GDP 0 GDP 1 AS AD 0 AD 1 The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 25

o P0P0 P1P1 P2P2 GDP 0 GDP 1 GDP 2 AS AD 0 AD 1 AD 2 The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 26

o P0P0 P1P1 P2P2 P3P3 GDP 0 GDP 1 GDP 2 GDP 3 AD 0 AD 1 AD 2 AD 3 AS The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 27

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Phillips Curve Concept & Canadian Data Figure 14-5

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Phillips Curve q Modern economists reject the idea of a stable, predictable long-run Phillips Curve q They agree there is a short-run tradeoff between inflation & unemployment

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Aggregate Supply Shocks & the Phillips Curve q In the late 1970s and early 1980s, the economy experienced stagflation

AdverseAggregateSupplyShocks

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Adverse Aggregate Supply Shocks q OPEC and Energy Prices q Other shocks: –agricultural shortfalls –dollar depreciation –wage increases after wage-price controls lifted –declining productivity

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter A Shifting Phillips Curve? Figure 14-6

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Stagflation’s Demise q by the late 80’s, it appeared the Phillips curve had shifted back –recession of –increased foreign competition –deregulation of airlines and trucking –decline in OPEC’s power

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Long-Run Phillips Curve q There is no apparent long-run tradeoff between inflation & unemployment

Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) The Long-Run Phillips Curve Figure 14-7 economy is at a 1 with unemployment at 5%, and inflation at 3%; suppose wages are set on the assumption of 3% inflation © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 37

Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) The Long-Run Phillips Curve suppose AD increases & inflation increases to 6%; economy moves to b 1 b1b1 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 38

Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) The Long-Run Phillips Curve but b 1 is not a stable equilibrium; workers will demand higher wages; economy moves to a 2 b1b1 a2a2 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 39

Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) The Long-Run Phillips Curve Phillips Curve shifts upward from PC 1 to PC 2 b1b1 a2a2 PC 2 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 40

Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) The Long-Run Phillips Curve scenario repeats if AD increases again b1b1 a2a2 PC 2 b2b2 a3a3 PC 3 so any rate of inflation is possible with the 5% natural rate of unemployment Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 41

Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) The Long-Run Phillips Curve b1b1 a2a2 PC 2 b2b2 a3a3 PC 3 the long-run Phillips Curve is vertical at the 5% natural rate of unemployment Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 42

Annual rate of inflation (percent) 3456 PC LR Unemployment rate (per cent) a3a3 PC c3c3 The Long-Run Phillips Curve what about disinflation? suppose the economy is at a 3 & AD declines Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 43

Annual rate of inflation (percent) 3456 PC LR Unemployment rate (per cent) a3a3 PC c3c3 The Long-Run Phillips Curve firms & workers eventually adjust to lower 6% inflation PC 2 a2a2 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 44

Annual rate of inflation (percent) 3456 PC LR Unemployment rate (per cent) a3a3 PC c3c3 The Long-Run Phillips Curve if AD falls further, the scenario will continue PC 2 a2a2 c2c2 PC 1 a1a1 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 45

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Taxation & Aggregate Supply q Government policies can impede or promote rightward shifts of AS q Effects of taxation on the supply curve are key concerns of supply side economics

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Taxes & Incentives to Work q Reductions in marginal tax rates on earned incomes induce more work q Lower marginal tax rates make leisure relatively more expensive

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Incentives to Save & Invest q Lower marginal tax rates increase the rewards for saving & investing q Saving is a prerequisite for investment

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Laffer Curve q It is possible that reductions in marginal tax rates will increase AS but leave tax revenues unchanged illustrated…

Laffer Curve Tax revenue (dollars) Shows impact of tax rates upon tax collections Tax rate (percent) Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 51

Laffer Curve Tax revenue (dollars) Tax rate (percent) l increase tax rates and tax revenues increase Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 52

Laffer Curve Tax revenue (dollars) m m Tax rate (percent) l tax revenues increase at a decreasing rate as rates rise further Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 53

Laffer Curve Tax revenue (dollars) m m Tax rate (percent) n l at some point, rates are so high that economic activity decreases, and cheating increases Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 54

Laffer Curve Tax revenue (dollars) m m Tax rate (percent) n l Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 55

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Criticisms of the Laffer Curve q Taxes, Incentives and Time –substitution effect as well as income effect q Inflation –demand side effects may be greater/quicker q Position on Curve –where are we?

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply