Bringing in the Supply Side: Unemployment and Inflation? 10

Bringing in the Supply Side Two main issues to address in this chapter 1.Does the economy have an efficient self correction mechanism? 2.What causes stagflation? 2

The Aggregate Supply (AS) Curve Aggregate supply curve The relationship between the price level and the quantity of real GDP supplied, all other determinants constant As the price level rises businesses are willing to produce more As the price level falls businesses are willing to produce less 3

Figure 1 An Aggregate Supply (AS) Curve 4 Real GDP Price Level S S Why does this relationship between the price level and real GDP exist? What variables are held constant when deriving this relationship?

The Aggregate Supply (AS) Curve Why does the aggregate supply curve slope upwards? Firms motivated by profit Unit profit = Price – Unit cost P = $10 and Unit cost = $5 = > profit = $5 Unit costs of inputs are assumed to be fixed for period of time – the short-run Higher selling prices for output makes production more attractive The largest input cost is the cost of labor – nominal wages and salaries. We assume this to be fixed in the short-run 5

Shifts of the Aggregate Supply (AS) Curve Holding the output level fixed what causes and increase or decrease in output? The nominal wage rate – money wage rate Higher wages cause production costs to increase and profits to fall Firms cut back on production Decrease in AS – curve shifts to left. The nominal wage rate – money wage rate Lower wages cause production costs to decrease and profits to increase Firms increase production Increase in AS – curve shifts to right. 6

A Shift of the Aggregate Supply Curve Decrease in AS 7 0 Real GDP (Y) Price Level (P) 6,000 5,500 S 0 (initial wages) S0S0 S 1 (higher wages) S1S1 100 A B

Shifts of the Aggregate Supply (AS) Curve Prices of other inputs Same effect on aggregate supply as with wages If other input cost increase, AS decrease. If other input cost decrease, AS increase What happened to the aggregate supply in fall 2014: It increased (shifted right) as energy prices fell Technology Improves labor productivity and reduces business costs So improvements in technology shift aggregate supply outward (right) 8

Figure 2 A Shift of the Aggregate Supply Curve 9 0 Real GDP (Y) Price Level (P) 6,000 6,500 S0S0 S0S0 S1S1 S1S1 100 A B Improvements in technology or decrease in world oil prices

Shifts of the Aggregate Supply (AS) Available supplies of labor and capital Labor force grows or improves in quality over time Capital stock increases (investment) over time Aggregate supply curve shifts outward (right) 10

Equilibrium of Aggregate Demand and Supply Equilibrium GDP Occurs where aggregate demand curve intersects aggregate supply curve Determines the equilibrium price level Aggregate quantity demanded equals aggregate quantity supplied 11

Figure 3 Equilibrium of Real GDP and the Price Level 12 5,200 5, ,0006,400 Real GDP (Y) 6, Price Level (P) D D S S E What happens when P = 120?

Equilibrium When P > P* (P = 120) Aggregate quantity supplied exceeds aggregate quantity demanded Firms unable to sell goods so inventories increase Production falls and firms decrease prices 13

Figure 3 Equilibrium of Real GDP and the Price Level 14 5,200 5, ,0006,400 Real GDP (Y) 6, Price Level (P) D D S S E What happens when P = 80?

Equilibrium When P < P* (P = 80) Aggregate quantity demanded exceeds aggregate quantity supplied Firms inventories run down and shortage of goods Production increases and firms increase prices 15

Inflation and the Multiplier How do rising prices affect the size of the multiplier? Simple multiplier = 1 / (1 – MPC) Base on a simple story: spending by one person is another person’s income... And, prices are assumed constant If the aggregate supply curve slopes upward Increase in aggregate demand pulls up the price level Purchasing power of consumer wealth falls and drains off some of the higher real demand Inflation reduces the value of multiplier 16

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

Recessionary and Inflationary Gaps Does equilibrium occur below or above potential GDP? Recessionary gap Amount by which the equilibrium level of real GDP falls short of potential GDP Caused by weak aggregate demand Inflationary gap Amount by which equilibrium real GDP exceeds the full-employment level of GDP Caused by excess aggregate demand 18

Figure 5(a) Recessionary and Inflationary Gaps Revisited 19 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

Figure 5(b) Recessionary and Inflationary Gaps Revisited 20 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

Figure 5(c) Recessionary and Inflationary Gaps Revisited 21 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 Deflation or Unemployment? What happens when there is a recessionary gap? Equilibrium real GDP less than potential GDP Cyclical unemployment If unemployment persistent, wages will eventually fall (question is how fast?) Aggregate supply increases: shifts outward (right) Price level falls and real GDP increases This process is called the “self-correcting” mechanism 22

Figure 6 The Elimination of a Recessionary Gap 23 Real GDP (Y) Price Level (P) Recessionary gap 5,000 6,000 Potential GDP B S0S0 S0S0 D D S 1 Lower wages S1S1 F E 100

Adjusting to a Recessionary Gap Deflation reduces the recessionary gap, bring economy back to potential Important catch? This “self-correcting” process could take a long time Japan for last 20 years 24

Adjusting to a Recessionary Gap Why nominal wages and prices won’t fall (easily) Economist speak: “Why are nominal wages and prices rigid”? Institutional factors Minimum wage, unions, regulations U.S. compared to Europe Psychological resistance to wage reduction Less severe business cycles Wait out the bad times rather than accept lower wages Firms do not want to lose best employees 25

Adjusting to a Recessionary Gap Implications of wage and price rigidity? With low aggregate demand, economy can get stuck in recessionary gap for long period Self-correcting mechanism: Refers to the way money wages and prices react to either a recessionary gap or an inflationary gap Wage changes shift the AS curve The economy will eventually recover to full employment But, how long will the process take? Political implications! 26

Adjusting to a Recessionary Gap 27 YearRecessionary gap (% of GDP) Change in Inflation in percentage points Question: What is the shortcoming of this type of analysis?

Figure 2 Actual and Potential GDP in U.S. 28

Adjusting to an Inflationary Gap How does economy recover when there is an inflationary gap? Equilibrium real GDP exceeds potential GDP. Labor in great demand, so firms start increasing wages Higher wages increase costs, so aggregate supply shifts left Economy returns to potential GDP at a higher price level 29

Figure 7 The Elimination of an Inflationary Gap 30 Real GDP (Y) Price Level (P) Inflationary gap Potential GDP B S0S0 S0S0 D D S1S1 S1S1 F E

Adjusting to an Inflationary Gap Some lessons about inflation in the real world Inflation can result when there is too much aggregate demand relative to potential GDP, called demand-pull inflation. Inflation can also result as the economy adjusts and AS decreases, called cost-push inflation. Stagflation Inflation that occurs while the economy is growing slowly or having a recession A stagnating economy with inflation 31

Adjusting to an Inflationary Gap What can we conclude from discussion of recessionary and inflationary gaps? A self-correction mechanism tends to eliminate either recessionary or inflationary gap It represents the adjustment process of the economy to reach full employment But, the process works slowly and unevenly Many economist do not think it’s a good idea to wait around for the process to complete – it may take 20 years. 32

Stagflation from a Supply Shock What caused high unemployment and inflation in 1970s and early 1980s? Classic example of stagflation 1973, and OPEC “Oil shocks” causes aggregate supply to shift left 33

Stagflation from an Adverse Shift in Aggregate Supply - Increase in world Oil price 34 S S0S0 D D S S1S1 A Real GDP Price Level (2009=100) 5,418 5, E What is the %-change in P? What is the %-change in RGDP?

Stagflation from a Supply Shock Stagflation is the typical result of adverse shifts of aggregate supply curve Cost-push inflation Real output falls and higher inflation Adverse aggregate supply shock is more serious than an adverse aggregate demand shock. We will see why in the next chapter. 35

Applying the Model to a Growing Economy From our simple model to the real world In real world both the price level and RGDP rise over time 36

Figure 9 The Price Level and Real GDP Output in the United States, 1972–

Applying the Model Every year both aggregate demand and supply shift right Aggregate demand shifts right because Population grows More demand for consumer and investment goods Increased government purchases Aggregate supply shifts right More workers, labor force grows Investment (more capital) and technology improve productivity 38

Figure 10 Aggregate Supply and Demand Analysis of a Growing Economy 39 S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2009 Dollars Price Level (P) (2009=100) 15,450 15, A: 2012 D1D1 D1D1 S1S1 S1S1 B: 2013

Applying the Model Demand-side fluctuations What happens if the aggregate demand grows faster or slower than before? 40

Figure 11 The Effects of Faster Growth of Aggregate Demand 41 S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2009 Dollars Price Level (P) (2009=100) 15,450 16, A D2D2 D2D2 S1S1 S1S1 C Higher output and higher inflation.

Figure 12 The Effects of Slower Growth of Aggregate Demand 42 S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2009 Dollars Price Level (P) (2009=2005) 15,450 15, A D3D3 D3D3 S1S1 S1S1 E

Applying the Model Holding aggregate supply growth constant Faster growth in aggregate demand leads to more inflation and faster growth in real output Slower growth in aggregate demand leads to less inflation and slower growth in real output Implies that rapid inflation occurs when output grows rapidly 43

Applying the Model Supply-side fluctuations What happens when there are adverse or positive supply shocks? 44

Figure 13 Stagflation from an Adverse Supply Shock 45 S0S0 S0S0 D0D0 D0D0 S1S1 S1S1 Real GDP (Y) in Billions of 2009 Dollars Price Level (2009=100) 5,418 5, A D1D1 D1D1 B

Figure 14 The Effects of a Favorable Supply Shock 46 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 Can have growth with stable prices.

Applying the Model Supply-side fluctuations If fluctuations in economic activity are a result from the supply side, higher inflation rates associated with lower rates of economic growth 47

A Role For Stabilization Policy Shifts in aggregate demand and supply causes fluctuations in real GDP and the price level Although the economy has a self-correcting mechanism it works slowly Can Government stabilization policy improve the workings of free market? The topic of the next few chapters 48