Chapter 10 Bringing in the Supply Side: 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

Why AS? Chapter 9 tells us change in AD will create inflationary gap vs. recessionary gap Which sort of gap will arise? priceNeed to know price level AS + AD determine price level supplyThis chapter: bring the supply side back

The Aggregate Supply Curve Aggregate supply curve –Each possible price level –Quantity of goods & services –All nation’s businesses - willing to produce –Specified period of time –All other determinants – constant Aggregate supply curve upward –Slopes upward 3

An aggregate supply curve Figure 1 4 Real GDP Price Level S S

The AS Curve: Why Upward Slope? Unit profit = Price – Unit cost Aggregate supply curve - slopes upward –Firms – purchase inputs Prices – fixed for some period of time –Higher selling prices – output Production – more attractive Aggregate supply curve –Shifts outward/right –More output produced Any given price level 5

The Aggregate Supply Curve Aggregate supply curve –Nominal wage rate –Nominal wage rate – increase Higher real production costs Aggregate supply curve – shifts inward/left –Prices of other inputs –Prices of other inputs – increase Higher real production costs Aggregate supply curve – shifts inward/left 6

A shift of the aggregate supply curve Figure Real GDP (Y) Price Level (P) 6,000 5,500 S 0 (lower wages) S0S0 S 1 (higher wages) S1S1 100 A B

The Aggregate Supply Curve Aggregate supply curve –Technology & productivity –Technology & productivity – improve Decrease business costs Aggregate supply curve – shift outward/right –Available supply of labor & capital –Available supply of labor & capital – better Labor force - grows or improves in quality Capital stock – increases (investment) Aggregate supply curve – shifts outward/right 8

Equilibrium: Aggregate Demand & Supply Equilibrium GDP –AD curve intersects AS curve –Equilibrium price level –Equilibrium quantity 9

Equilibrium of real GDP and the price level Figure ,200 5, ,0006,400 Real GDP (Y) 6, Price Level (P) D D S S E

Equilibrium: Aggregate Demand & Supply For price level > Equilibrium price level –Aggregate quantity supplied exceeds Aggregate quantity demanded –Inventories – increase Prices – forced down –Price level – falls –Production – falls 11

Equilibrium: Aggregate Demand & Supply For price level < Equilibrium price level –Aggregate quantity demanded exceeds Aggregate quantity supplied –Shortage of goods –Inventories – decrease Prices – increase –Price level – rise –Production – rise 12

Determination of the equilibrium price level Table 1 13 (1)(2)(3)(4)(5) Price Level Aggregate Quantity Demanded Aggregate Quantity Supplied Balance of Supply and Demand Prices will be: $6,400 6,200 6,000 5,800 5,600 $5,600 5,800 6,000 6,200 6,400 Demand exceeds supply Demand equals supply Supply exceeds demand Rising Unchanged Falling falling

Inflation and the Multiplier Aggregate supply curve – slopes upward –Any increase in aggregate demand Price level – increase Erodes purchasing power of consumer wealth Reduces net exports –Inflation – reduces value of multiplier 14

Inflation and the multiplier Figure ,0006,400 Real GDP (Y) 6, Price Level (P) D0D0 D0D0 S S D1D1 D1D1 A $800 billion E1E1 E0E0

Recessionary & Inflationary Gaps Recessionary gap –Equilibrium GDP < Potential GDP –Aggregate demand – weak Inflationary gap –Equilibrium GDP > Potential GDP –Excess aggregate demand 16

Recessionary and inflationary gaps revisited Figure 5 (a) 17 Real GDP Real Expenditure 45° C+I 0 +G+(X-IM) 6,000 7,000 Potential GDP B E Recessionary gap 0 Real GDP Price Level Recessionary gap 6,000 7,000 Potential GDP B S S D0D0 D0D0 E

Recessionary and inflationary gaps revisited Figure 5 (b) 18 Real GDP Real Expenditure 45° C+I 1 +G+(X-IM) 7,000 Potential GDP E 0 Real GDP Price Level 7,000 Potential GDP S S D1D1 D1D1 E

Recessionary and inflationary gaps revisited Figure 5 (c) 19 Real GDP Real Expenditure 45° C+I 2 +G+(X-IM) 8,000 7,000 Potential GDP B E Inflationary gap 0 Real GDP Price Level Inflationary gap 8,000 7,000 Potential GDP B S S D2D2 D2D2 E

Adjusting to a Recessionary Gap Recessionary gap  cyclical unemployment   wage  outward  AS curve shifts outward  Y , P  self-correcting mechanismIt is a self-correcting mechanism 20

The elimination of a recessionary gap Figure 6 21 Real GDP (Y) Price Level (P) Recessionary gap 5,000 6,000 Potential GDP B S0S0 S0S0 D D S1S1 S1S1 F E 100

Adjusting to a Recessionary Gap In reality, wages & prices rarely fall –Institutional factors: minimum wage law, union contracts –Psychological resistance to wage reduction –Business cycles – less severe –Firms – don’t want to lose best employees Economy - get stuck –Recessionary gap - long period 22

Adjusting to Inflationary Gap: Inflation Inflationary gap  over employment  wage  inward  AS shifts inward  Y , P  self-correctingAgain, it is a self-correcting mechanism 23

The elimination of an inflationary gap Figure 7 24 Real GDP (Y) Price Level (P) Inflationary gap Potential GDP B S0S0 S0S0 D D S1S1 S1S1 F E

Adjusting to Inflationary Gap: Inflation Self-correcting mechanism –Takes time Stagflation –Inflation and economic stagnation –Normal – after excessive aggregate demand 25

Stagflation from a Supply Shock Higher energy prices –Aggregate supply – shift inward –“Oil shocks” Adverse supply shocks –Inward shift of aggregate supply –Falling production –Rising prices 26

Stagflation from an adverse shift in aggregate supply Figure 8 27 S0S0 S0S0 D D S1S1 S1S1 A Real GDP Price Level (2000=100) 4,342 4, E

Applying Model to a Growing Economy Simple model –Aggregate demand –Aggregate supply –Equilibrium price level –Equilibrium level of real GDP U.S. : price level & real GDP, –Higher price level –Higher GDP –Growth & Inflation 28

The price level & real GDP output in U.S., 1972–2007 Figure 9 29

Applying Model to a Growing Economy Every year –Aggregate demand – grows Shift right Growing population –More demand: consumer & investment goods Increased government purchases –Aggregate supply – shift right More workers Investment & technology –Improve productivity 30

Aggregate supply & demand analysis: growing economy Figure S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2000 Dollars Price Level (P) (2000=100) 11,000 11, A D1D1 D1D1 S1S1 S1S1 B

Applying Model to a Growing Economy Demand-side fluctuations –For Aggregate supply – grows, and If: Aggregate demand – grows faster –Faster growth –More inflation –Economic boom If: Aggregate demand – grows slower –Slower growth –Less inflation –Economic recession 32

The effects of faster growth of aggregate demand Figure S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2000 Dollars Price Level (P) (2000=100) 11,000 11, A D2D2 D2D2 S1S1 S1S1 C

The effects of slower growth of aggregate demand Figure S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2000 Dollars Price Level (P) (2000=100) 11,000 11, A D3D3 D3D3 S1S1 S1S1 E

Applying Model to a Growing Economy Supply-side fluctuations –For Aggregate demand – grows, and If: Aggregate supply – shifts inward –Real output – decline slightly –Prices – rapid increase –Stagflation If: Aggregate supply – grows faster –Favorable supply shock –Faster economic growth –Lower inflation 35

Stagflation from an adverse supply shock Figure S0S0 S0S0 D0D0 D0D0 S1S1 S1S1 Real GDP (Y) in Billions of 2000 Dollars Price Level (2000=100) 4,342 4, E D1D1 D1D1 B

The effects of a favorable supply shock Figure Real GDP (Y) Price Level (P) S0S0 S0S0 D0D0 D0D0 A D1D1 D1D1 S1S1 S1S1 B C Normal growth of aggregate supply Effect of favorable supply shock

Big Picture compositionChapter 8: composition of AD and the volatility of investment multiplierChapter 9: changes in investment have multiplier effects on AD (given price) GDP priceThis chapter: show how shifts in AD curve cause fluctuations in both GDP and price 38

A Role For Stabilization Policy Economy’s self-correcting mechanism –Works slowly Government stabilization policy –Improve workings of free market

Summary AS curve: upward slope Shifts of AS curve Equilibrium of AS-AD Self-Correcting Mechanism of Economy The process might be slow Need government stabilization policy