1. Mehdi Arzandeh, University of Manitoba
PowerPoint Presentation by
Mehdi Arzandeh, University of Manitoba

2. © 2016 McGraw‐Hill Education Limited
Long-Run Macroeconomic Adjustments 16
LEARNING OBJECTIVES
LO16.1 Explain how the economy arrives at its long-run equilibrium.
LO16.2 Explain how to apply the long-run AD–AS model to explain inflation, recessions, and growth.
LO16.3 Explain the short-run trade-off between inflation and unemployment (the Phillips Curve).
LO16.4 Discuss why there is no long-run trade-off between inflation and unemployment.
LO16.5 Explain the relationship among tax rates, tax revenues, and aggregate supply.
© 2016 McGraw‐Hill Education Limited

3. © 2016 McGraw‐Hill Education Limited
16.1
From the Short Run to the Long Run
Short-Run Aggregate Supply
Input prices are inflexible
aggregate supply curve is upwardly sloping
Long-Run Aggregate Supply
Input prices are fully flexible
Vertical aggregate supply
The transition
LO1
© 2016 McGraw‐Hill Education Limited

4. © 2016 McGraw‐Hill Education Limited
16.1
From the Short Run to the Long Run
From the Short-Run AS to the Long-Run AS
Production above potential output:
High demand for inputs
Input prices rise
Short run aggregate supply shifts left
Return to potential output
Production below potential output
Lower demand for inputs
Input prices fall
Short run aggregate supply shifts right
LO1
© 2016 McGraw‐Hill Education Limited

5. © 2016 McGraw‐Hill Education Limited
LO4.1
FIGURE 16-1
Short-Run and Long-Run Aggregate Supply
Short-Run
Aggregate Supply
Long-Run
Aggregate Supply
AS1
ASLR
AS2
AS1 a2 b1 a2
AS3 P2 P2
Price Level a1
Price Level a1 P1 P1 a3 a3 P3 P3 c1
GDP3
GDPf
GDP2
GDPf
Real Domestic Output, GDP
Real Domestic Output, GDP
LO1
© 2016 McGraw‐Hill Education Limited

6. © 2016 McGraw‐Hill Education Limited
LO4.1
FIGURE 16-2
Equilibrium in the Long-Run AD-AS Model
ASLR
AS1
Price Level P1 a
AD1
GDPf
Real Domestic Output
LO1
© 2016 McGraw‐Hill Education Limited

7. © 2016 McGraw‐Hill Education Limited
Applying the Long-Run AD-AS Model
16.2
Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level
LO2
© 2016 McGraw‐Hill Education Limited

8. © 2016 McGraw‐Hill Education Limited
LO4.1
FIGURE 16-3
Demand-Pull Inflation in the Long-Run AD-AS Model
AS2
ASLR
AS1 P3 c P2 b
Price Level P1 a
AD2
AD1
This graph demonstrates the effects of demand-pull inflation on the model. Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level. Since the demand-pull inflation causes the aggregate demand curve to shift to the right, it causes the price level to increase, which expands output to a higher level. Since the economy is now producing above the potential output, inputs are in high demand, which in the long run causes their prices to also adjust upwards. This therefore causes the short run aggregate supply curve to shift upwards, moving equilibrium back to the long run aggregate supply curve. In the short run, demand pull inflation increases both the price level and real output, but in the long run only the price level will increase as output will always return to the full-employment level. Qf Q2
Real Domestic Output
LO2
© 2016 McGraw‐Hill Education Limited

9. © 2016 McGraw‐Hill Education Limited
Applying the Long-Run AD-AS Model
16.2
Demand-Pull Inflation
In the short run, demand-pull inflation drives up prices and output
In the long run, output is restored to GDPf and only the price level is higher
LO2
© 2016 McGraw‐Hill Education Limited

10. © 2016 McGraw‐Hill Education Limited
Applying the Long-Run AD-AS Model
16.2
Cost-Push Inflation
Cost-push inflation arises from factors that increase the cost of production at each price level
LO2
© 2016 McGraw‐Hill Education Limited

11. © 2016 McGraw‐Hill Education Limited
LO4.1
FIGURE 16-4
Cost-Push Inflation in the Long-Run AD-AS Model
AS2
ASLR
AS1 P3 c P2 b
Price Level P1 a
AD2
AD1
Under cost-push inflation, factors have arisen that have increased the cost of production at each level of production, causing the short run aggregate supply curve to shift upwards and increase the price level. Cost-push inflation typically causes inflationary pressures on the economy, and government usually will move to counter the negative effects by using fiscal and monetary policy to increase aggregate demand. This only ends up moving the prices even higher as the economy seeks to return to the natural full-employment level of output. If the government does not take action, the economy will eventually return on its own to the natural level, but the process will be painful as wide-spread business failures, layoffs, and plant closures usually follow the process. So the government ends up between a rock and a hard place: do nothing and deal with an extended recession, or take action and end up with higher inflation. Q2 Qf
Real Gross Domestic Product, GDP
LO2
© 2016 McGraw‐Hill Education Limited

12. © 2016 McGraw‐Hill Education Limited
Applying the Long-Run AD-AS Model
16.2
Cost-Push Inflation: Policy Dilemma
If government attempts to maintain full employment, an inflationary spiral may occur
Otherwise, the recession will linger, with high unemployment and a loss of real output
LO2
© 2016 McGraw‐Hill Education Limited

13. © 2016 McGraw‐Hill Education Limited
LO4.1
FIGURE 16-5
Recession in the Long-Run AD-AS Model
ASLR
AS1
AS2 P1 a P2 b
Price Level P3 c
AD1
AD2
The most challenging issue to deal with is the effect of recession on the model. In a recession, aggregate demand declines and shifts left, which reduces prices. The economy will be producing less, so the demand for inputs will be low. Eventually nominal wages will drop. Once the wages fall, aggregate supply will decrease, which will decrease prices further. We are back at the long run equilibrium of full-employment, but at a much lower price level. Q1 Qf
Real Domestic Output
LO2
© 2016 McGraw‐Hill Education Limited

14. Productions Possibilities Long Run Aggregate Supply
Production Possibilities and Long-Run Aggregate Supply
FIGURE 16-6
Productions Possibilities
Long Run Aggregate Supply C
𝑨𝑺 𝑳𝑹𝟏
𝑨𝑺 𝑳𝑹𝟐 A
Capital Goods
Price Level
Economic growth is illustrated by either an outward shift on the production possibilities curve or a rightward shift in the long run aggregate supply curve. As the curves shift, they will lead to price increases at a new equilibrium level. Prices very rarely decrease in the long run. Why not? The Federal Reserve will increase the money supply to create rightward shifts in the aggregate demand curve. B D
𝑮𝑫𝑷 𝟏
𝑮𝑫𝑷 𝟐
Consumer Goods
Real GDP
Increase in production possibilities
Increase in long-run aggregate supply
LO2
© 2016 McGraw‐Hill Education Limited

15. © 2016 McGraw‐Hill Education Limited
Applying the Long-Run AD-AS Model
16.2
Recession and the Long-Run AD-AS Model
How long would it take in the real world for price and wage adjustments to occur to regain full employment?
There is disagreement among economists
LO2
© 2016 McGraw‐Hill Education Limited

16. © 2016 McGraw‐Hill Education Limited
Applying the Long-Run AD-AS Model
16.2
Ongoing Inflation in the Long-Run AD-AS Model
Modern economies tend to experience positive rates of inflation due to
Economic growth causing rightward shifts of the AS curve
Central banks then cause rightward shifts of the AD curve so that it proceeds just a little faster than the deflationary rightward shifts of the AS curve
The net effect is (usually) a small positive rate of inflation
LO2
© 2016 McGraw‐Hill Education Limited

17. © 2016 McGraw‐Hill Education Limited
LO4.1
Depicting Canadian Growth in the Long-Run AD-AS Model
FIGURE 16-7
ASLR1
ASLR2
AS2
AS1 P2
Price level P1
AD2
The whole key to managing inflation is for the Bank of Canada to use monetary policy to shift the aggregate demand curve to the right faster than the supply factors of economic growth shift the long-run aggregate supply curve to the right. An economy can withstand mild inflation as long as it is occurring at a slow pace. It is the sudden shifts in the curve that cause economic chaos.
AD1 Q1 Q2
Real GDP
LO2
© 2016 McGraw‐Hill Education Limited

18. © 2016 McGraw‐Hill Education Limited
Applying the Long-Run AD-AS Model
16.2
Long-Run AD-AS Model
Economic growth causes increases in long-run aggregate supply
Whether deflation, or inflation accompanies growth depends on the extent to which aggregate demand increases relative to aggregate supply
Any inflation that occurs is the result of growth of aggregate demand
It is not the result of the growth of real GDP
LO2
© 2016 McGraw‐Hill Education Limited

19. © 2016 McGraw‐Hill Education Limited
The Inflation-Unemployment Relationship
16.3
Under normal circumstances, there is a short-run tradeoff between inflation & unemployment
Aggregate supply shocks can cause both higher inflation and higher unemployment
There is no significant tradeoff between inflation and unemployment over long periods of time
LO3
© 2016 McGraw‐Hill Education Limited

20. © 2016 McGraw‐Hill Education Limited
LO4.1
FIGURE 16-8
Phillips Curve: Concept and Canadian Empirical Data
Empirical Data
Data for the 1960s
The Concept
Annual Rate of Inflation (Percent)
Unemployment Rate (Percent)
Annual Rate of Inflation (Percent)
. 68
. 69
. 67
. 66
. 65
. 64
. 63
. 62
. 61
Unemployment Rate (Percent)
LO3
© 2016 McGraw‐Hill Education Limited

21. © 2016 McGraw‐Hill Education Limited
LO4.1
The Short-Run Effect of Changes in Aggregate Demand on Real Output and the Price Level
FIGURE 16-9 AS P3
Price Level P2
AD3 P1
AD2 P0
AD1
This idea is apparent here as we look at the short run aggregate supply curve illustrated in this graph. Here you can see that as aggregate demand expands, in the short run the price level increases. As the price level increases, firms will increase production, which in turn will lead to higher employment. We will end up with the downward sloping Phillips curve in the next slide.
AD0 Q0 Q1 Q2 Q3
Real GDP
LO3
© 2016 McGraw‐Hill Education Limited

22. © 2016 McGraw‐Hill Education Limited
The Inflation-Unemployment Relationship
16.3
The Phillips Curve
Modern economists reject the idea of a stable, predictable long-run Phillips Curve
They agree there is a short-run tradeoff between inflation and unemployment
LO3
© 2016 McGraw‐Hill Education Limited

23. © 2016 McGraw‐Hill Education Limited
The Inflation-Unemployment Relationship
16.3
Aggregate Supply Shocks and the Phillips Curve
In the late 1970s and early 1980s, the economy experienced stagflation
LO3
© 2016 McGraw‐Hill Education Limited

24. © 2016 McGraw‐Hill Education Limited
The Inflation-Unemployment Relationship
16.3
Adverse Aggregate Supply Shocks
OPEC and Energy Prices
Other shocks:
Agricultural shortfalls
Dollar depreciation
Wage increases after wage-price controls lifted
Declining productivity
LO3
© 2016 McGraw‐Hill Education Limited

25. © 2016 McGraw‐Hill Education Limited
LO4.1
Inflation Rates and Unemployment Rates in Canada,
FIGURE 16-10
Needs update?
LO3
© 2016 McGraw‐Hill Education Limited

26. © 2016 McGraw‐Hill Education Limited
The Inflation-Unemployment Relationship
16.3
Stagflation’s Demise
By the late ‘80s, it appeared the Phillips curve had shifted back
Recession of ‘81-’83
Increased foreign competition
Deregulation of airlines and trucking
Decline in OPEC’s power
These factors also helped to reduce per-unit production costs and to shift the short-run AS curve rightward
LO3
© 2016 McGraw‐Hill Education Limited

27. © 2016 McGraw‐Hill Education Limited
16.1 GLOBAL PERSPECTIVE
The Misery Index, Selected Nations,
This graph measures the effect of inflation and high unemployment on a nation’s mental health. Note that Canada is typically in the middle range.
LO3
© 2016 McGraw‐Hill Education Limited

28. © 2016 McGraw‐Hill Education Limited
16.4
The Long-Run Phillips Curve
There is no apparent long-run tradeoff between inflation and unemployment
The Short-Run Phillips Curve
Expectation and the Long-Run Vertical Phillips Curve
Disinflation
LO4
© 2016 McGraw‐Hill Education Limited

29. © 2016 McGraw‐Hill Education Limited
LO4.1
FIGURE 16-11
The Long-Run Vertical Phillips Curve
PCLR 3 6 9 12 15
PC3 b3
PC2 a3
Annual Rate of Inflation (Percent) b2
PC1 a2 c3 b1 a1 c2 3 4 5 6
Unemployment Rate (Percent)
LO4
© 2016 McGraw‐Hill Education Limited

30. © 2016 McGraw‐Hill Education Limited
16.5
Taxation and Aggregate Supply
Taxes and Incentives to Work
Government policies can impede or promote rightward shifts of AS
Effects of taxation on the supply curve are key concerns of supply-side economics
LO5
© 2016 McGraw‐Hill Education Limited

31. © 2016 McGraw‐Hill Education Limited
16.5
Taxation and Aggregate Supply
Incentives to Save and Invest
Lower marginal tax rates increase the rewards for saving and investing
Saving is a prerequisite for investment
LO5
© 2016 McGraw‐Hill Education Limited

32. Shows impact of tax rates
LO4.1
FIGURE 16-12
The Laffer Curve
Shows impact of tax rates
upon tax collections
100 n
Lower Tax Revenue Above m
Tax rate (percent) m
Maximum Tax Revenue l
Tax revenue (dollars)
LO5
© 2016 McGraw‐Hill Education Limited

33. © 2016 McGraw‐Hill Education Limited
16.5
Taxation and Aggregate Supply
Criticisms of the Laffer Curve
Taxes, Incentives and Time
Empirical evidence shows the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge
Inflation or Real Interest Rates
Demand side effects may be greater/quicker and certain
Position on the Curve
Rebuttal and Evaluation
LO5
© 2016 McGraw‐Hill Education Limited

34. © 2016 McGraw‐Hill Education Limited
LO4.1
The LAST WORD
Do Tax Increases Reduce Real GDP?
Determining the relationship between changes in taxes and permanent changes in real GDP is fraught with complexities and difficulties. University of California-Berkeley economists Christina Romer and David Romer have recently devised a novel way to approach the topic. Their findings suggest that tax increases reduce real GDP.
On average, when economic activity rises more rapidly, tax revenues also are rising more rapidly
Romer and Romer find that most tax changes are motivated by:
counteracting other influences in the economy;
paying for increases in government spending (or lowering taxes in conjunction with reductions in spending);
addressing an inherited budget deficit;
promoting long-run growth
A tax increase of 1 percent of GDP lowers real GDP by roughly 2 to 3 percent.
Romer and Romer find that tax increases to reduce an inherited budget deficit have much smaller output costs than other tax increases.
© 2016 McGraw‐Hill Education Limited

35. © 2016 McGraw‐Hill Education Limited
LO4.1
Chapter Summary
LO16.1 Explain how the economy arrives at its long-run equilibrium. LO16.2 Explain in how to apply the long-run AD–AS model to explain inflation, recessions, and growth. LO16.3 Explain the short-run trade-off between inflation and unemployment (the Phillips Curve). LO16.4 Discuss why there is no long-run trade-off between inflation and unemployment. LO16.5 Explain the relationship among tax rates, tax revenues, and aggregate supply.
© 2016 McGraw‐Hill Education Limited