1. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. January – Chapter 10 ●Project – Jan. 11 th ●Exams= Jan. 25 nd -29 th ●Chapter 10 ♦Quiz Wed. ♦Test Fri. ●Project – Jan. 11 th ●Exams= Jan. 25 nd -29 th ●Chapter 10 ♦Quiz Wed. ♦Test Fri.

2. 10 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

3. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #1 ●Define the parameters of the supply curve and supply side shift causes.

4. Copyright© 2006 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.

5. Copyright© 2006 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.

6. Copyright© 2006 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 (Problem #2) ■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 (Problem #2) ■The money wage rate ■Prices of other inputs ■Technology and productivity ■Available supplies of labor and capital

7. Copyright© 2006 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 (Problem #1) ■Interest rate ■Materials prices ●Shifts of the Aggregate Supply Curve ♦  cost of production  inward shift of AS curve ■Money wage rate (Problem #1) ■Interest rate ■Materials prices

8. Copyright© 2006 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

9. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Recent Adjustments to Supply ●Toll Hikes ●Plan to increase min-wage to $8.25 (wage-price spiral) ●Immigration Reform ●$100+ to $30 barrel of oil ●Fed cuts “r”.25 points ●Toll Hikes ●Plan to increase min-wage to $8.25 (wage-price spiral) ●Immigration Reform ●$100+ to $30 barrel of oil ●Fed cuts “r”.25 points

10. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #2 ●Explain the equilibrium and the effects of supply side effects of the multiplier.

11. Copyright© 2006 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

12. TABLE 1: Determination of the Equilibrium Price Level Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

13. Copyright© 2006 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

14. Copyright© 2006 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

15. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #3 ●Explain the equilibrium and the effects of supply side recessionary/inflationary issues.

16. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Recessionary and Inflationary Gaps Revisited ●Long-run: market forces make equilibrium GDP = potential GDP

17. Copyright© 2006 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

18. Copyright© 2006 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

19. Copyright© 2006 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

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ●With sticky wages, cyclical unemployment may last a long time.

21. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ●Does the Economy Have a Self-Correcting Mechanism? (Graph This!!) ♦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? (Graph This!!) ♦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.

22. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap (Graph This) ●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

23. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ●Stagflation = inflation that occurs while the economy is growing slowly or having a recession

24. Copyright© 2006 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.

25. Copyright© 2006 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.

26. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Stagflation from a Supply Shock (Graph This!!!) ●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.

27. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #4 ●Describe how a growing economy effects the economic model.

28. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Applying the Model to a Growing Economy ●Aggregate demand and aggregate supply grow over time ♦Aggregate demand ■Growing population → more demand for consumption and investment goods ■Government spending ♦Aggregate supply ■More workers join the labor force ■Investment and technology improve ●Aggregate demand and aggregate supply grow over time ♦Aggregate demand ■Growing population → more demand for consumption and investment goods ■Government spending ♦Aggregate supply ■More workers join the labor force ■Investment and technology improve

29. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Applying the Model to a Growing Economy ●Demand-side fluctuations ♦Growth in AD (Graph) ■Faster growth → more inflation and faster growth in real output ■Slower growth → less inflation and slower growth in real output ♦If economic fluctuations arise because of variation in AD growth ■higher inflation → rapid output growth ■slower inflation → slow output growth ●Demand-side fluctuations ♦Growth in AD (Graph) ■Faster growth → more inflation and faster growth in real output ■Slower growth → less inflation and slower growth in real output ♦If economic fluctuations arise because of variation in AD growth ■higher inflation → rapid output growth ■slower inflation → slow output growth

30. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Applying the Model to a Growing Economy ●Supply-side fluctuations ♦If economic fluctuations arise because of variation in AS growth (Graph) ■higher inflation → lower output growth ♦Favorable supply shocks increase output and reduce inflation ●Supply-side fluctuations ♦If economic fluctuations arise because of variation in AS growth (Graph) ■higher inflation → lower output growth ♦Favorable supply shocks increase output and reduce inflation

31. Copyright© 2006 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