AD-AS Model Part III: Putting it all together

Stick Wages  Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages.  Nominal wages cannot be sticky forever. The length of their stickyness is the difference in the short and long run

3 Ranges of the Segmented AS Curve 1. Keynesian 2. Intermediate 3. Classical PL AS (3) (2) (1) RGDP

Long Run Aggregate Supply Prices are relative. If your pay is cut by 50% but all prices drop by 50% your income has the same value

LR Aggregate Supply The upward slope of the SRAS is due to sticky wages / other prices, BUT wages always adjust / are renegotiated in the LR LR -- ALL inputs are flexible & PL has NO effect on quantity of output supplied

LR Aggregate Supply o LRAS’s position on the horizontal axis represents the speed limit or potential (non- inflationary) level of output (i.e. full employment)

LR Aggregate Supply  Actual RGDP is almost always above or below FE (Full Employment) [i.e. at a SR equilibrium]  Potential output for the U.S. has grown steadily over time

LR Aggregate Supply Shifts in LRAS due to:   in labor force   in physical capital   in natural resources   in human capital   in technology Same reasons the PPC shifts

Moving from the SR to the LR If the economy is almost always on its SRAS, why is LRAS relevant? Over time, the SRAS will shift to restore the LR equilibrium Actual output will eventually reach potential output

Putting AS & AD Together  Movement along a curve occurs because the other curve has shifted. To understand the economy, you need both curves (and LRAS). PL SRAS AD 0 AD 1 RGDP

SR Macroeconomic Equilibrium The intersection of SRAS & AD is equilibrium: quantity of total output supplied = Q demanded by C + I + G + (X - M). It shows PL & RGDP Below equilibrium, PL will rise because there is a shortage. Above equilibrium, PL will fall because there is a surplus. PL SRAS AD RGDP P* Y*

Negative Supply Shock Darth Vader attacks Dathomir.

Shifts in SRAS (Supply Shocks) 1. Negative Supply Shock --Some  in production costs (e.g. increasing commodity prices, increasing nominal wages, decline in productivity) --Shifts SRAS to the left -- PL  (inflation up) -- RGDP  (unemployment up) PL LRAS SRAS 1 SRAS 0 AD RGDP FEY1Y1 P* P1P1

Negative SRAS Shock: Phillips Connection Result: stagflation (means stagflation + inflation) = worst of all possible worlds = right shift of SR Phillips Curve (cost-push inflation) What should we try to fix first? Inflation Unemployment SRPC 0 SRPC 1

Positive Supply Shock Luke Skywalker comes and saves the day

Shifts in SRAS (Supply Shocks) 2. Positive Supply Shock --Some  in production costs (e.g. decreasing input prices, increase in productivity) --Shifts SRAS to the right -- PL  (inflation down) -- RGDP  (unemployment down) Result: best of all possible worlds Full employment & disinflation creates waves of national optimism PL LRAS SRAS 0 SRAS 1 AD RGDP FEY1Y1 P1P1 P*

Negative SRAS Shock: Phillips Connection 2. Positive Supply Shock The Short Run Phillips Curve shifts LEFT Improved menu of tradeoffs How can we keep this going? inflation unemployment SRPC 0 SRPC 1

Shifts in AD: Demand Shocks 1. Negative Demand Shock: Recession caused by a leftward shift in AD (e.g. a  in wealth, oversupply of stock of capital, contractionary fiscal or monetary policy) This dude is literally tightening his belt. This was actually a movie

Shifts in AD: SR Demand Shocks When AD shifts left… Result: Recession PL  (disinflation or deflation) RGDP  (unemployment  ) Ex Recession & Great Depression LRAS SRAS PL RGDP AD 1 AD 0 P* P1P1 Y1Y1 FE

Negative AD Shock: Phillips Connection Left Shift in Aggregate Demand corresponds to… Movement downward along the Phillips Curve Tradeoff between inflation and unemployment inflation unemployment SRPC

Shifts in AD: SR Demand Shocks 2. Positive Demand Shock -- demand-pull boom caused by a right shift in AD (e.g. an  in wealth, undersupply of stock of capital, expansionary fiscal or monetary policy

Shifts in AD: SR Demand Shocks AD shifts right… Result: Inflationary Boom PL  (demand-pull inflation) RGDP  (unemployment  ) Ex. Spending on WWII & Great Society LRAS SRAS PL P1P1 P* FEY1Y1 RGDP AD 0 AD 1

Positive AD Shock: Phillips Connection Right shift in AD corresponds to… Movement upward along the Phillips Curve Tradeoff between unemployment and inflation inflation unemployment SRPC

In the LR the economy self-corrects  Negative D shock  PL & RGDP  AD moves  SRAS b/c sticky wages are not falling as fast as product market prices (businesses lay off workers or shut down b/c of  profitability)   unemployment  bargaining power of workers; nominal wages    in cost of production shifts SRAS to the right until FE equilibrium (LRAS equilibrium) is restored  Net result: same FE level (RGDP) at a lower PL PLLRASSRAS 0 SRAS 1 AD 1 AD 0 RGDP Recessionary Gap 1 2

While this explanation makes waiting for the LR adjustment look quite desirable, SR recessions can be very disruptive to the population.

Positive Ag. Demand Shock   PL & RGDP  AD moves  SRAS b/c sticky wages are not rising as fast as product market prices (firms ratchet up production, hire more workers, & add shifts b/c of  profitability)  Tight labor market  bargaining power of firms; nominal wages    in cost of production shifts SRAS to the left until FE equilibrium (LRAS equilibrium) is restored  Net result: same FE level (RGDP) at a higher PL PLLRASSRAS 1 SRAS 0 AD 0 AD 1 RGDP Inflationary Gap

From LR to SR How long does it take to move from SR to LR? *answer depends on whether you believe in Adaptive or Rational Expectations Adaptive ExpectationsRational Expectations

Adaptive Expectations  The economy moves from the short run to the long run slowly because individuals respond to events as / after they happen  People are largely reactive to events “on the ground”

Rational Expectations  The economy moves from SR to LR quite quickly b/c people have an intuitive understanding of the economic forces at work & react immediately to where the economy is going.  They make decisions optimally, using all available information.  e.g. if a union is negotiating a contract during a period of current & past low inflation and announced gov’t policy indicates that the G will be trying to trade a  PL for  unemployment, then the union will put that future inflation into the new contract, sabotaging G efforts to move up the SRAS -- instead go straight to same RGDP at a higher PL.

Implications: LR or “Extended” Phillips Curve 3 Generalizations 1. Under normal circumstances there is a SR tradeoff between the rate of inflation & the rate of unemployment 2. Aggregate supply shocks can cause both  rates of inflation &  rates of unemployment 3. There is no significant tradeoff between inflation & unemployment over long periods of time Inflation Unemployment SRPC 0 SRPC 1 LRPC