1. Extending the Analysis of Aggregate Supply
Chapter 18
First…until now we have assumed the AS curve remains stable when the AD curve shifts. I.E. when the AD curve increases, there is an increase in price and real output. This is accurate in the short run. There are at least two reasons why nominal wages may for a time be unresponsive to changes in the price level.
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2. From Short Run to Long Run
Two reasons why nominal wages may for a time be unresponsive to changes in price level
Workers may not immediately be aware of the extent to which inflation has changed their real wages, and thus they may not adjust their labor supply decisions & wage demands accordingly
Many employees are hired under fixed-wage contracts (I.e. unionized workers)…
Price level changes do not immediately give rise to changes in nominal wages
Once labor contracts expire, wages can be adjusted
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3. Long-Run
Once contracts have expired and nominal wages have been adjusted, the economy enters the long run
Nominal wages are fully responsive to previous changes in price level
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4. Short-Run AS
Nominal wages do not respond to price-level changes based on the expectation that price level (p1) will continue.
An increase in price level increases prices & profits & output
A decrease in price level reduces profits & real output
Figure 15.1a…3 assumptions
Initial price level is p1.
Firms & workers have established nominal wages on the expectation that this price level will persist.
The price level is flexible (both up & down)
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5. Long-Run AS A rise in the price level results in higher nominal wages
AS curve shifts to left
Decrease in price level reduces nominal wages
AS curve shifts to right
After such adjustments, the economy obtains equilibrium at a different point on the curve
LR AS curve is vertical
Figure 15.1b
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6. Long-Run Equilibrium in the AD-AS Model
SRAS curve adjusts
After those adjustments, long-run equilibrium occurs where all three curves intersect
Figure 15.2…the LR equilibrium price level (p1) and level of real output (qf) occur at the intersection of the AD1 curve, LRAS, and SRAS (AS1)
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7. Demand-Pull Inflation in the Extended AD-AS Model
An increase in the price level eventually leads to an increase in nominal wages
SRAS curve will shift left
Real output will return to its prior level and price level rises even more
In this scenario, the economy moves from a to b and then eventually to c.
In the short run, demand-pull inflation drives up the price level & increases real output; in the long run, only the price level rises
Figure 15.3
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8. Cost-Push Inflation in the Extended AD-AS Model
Occurs when the SRAS curve shifts leftward
If government counters the decline in real output by increasing AD, the price level will rise even more
In contrast, if government allows a recession to occur (I.e. no increase in AD), nominal wages fall
AS curve shifts back to original location
Figure 15.4…
4. Curve goes from a to b and back to a
This analysis yields two generalizations:
If the govt. attempt to maintain full employment when there is cost-push inflation, an inflationary spiral may occur.
If the govt. takes a hands-off approach to cost-push inflation, a recession will occur.
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9. Recession & the Extended AD-AS Model
A recession occurs when AD shifts left
If prices & wages are downwardly flexible, the price level falls
The decline in price level eventually reduces nominal wages & shifts AS curve to right
Price level continues to decline, but real output increases back to original output (neg. GDP gap evaporates w/no need for expansionary fiscal or monetary policy)
Figure 15.5…from point a to b to c
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10. The Inflation-Unemployment Relationship
Important because low inflation & unemployment are major economic goals.
Are they compatible or conflicting?
Three generalizations
Under normal circumstances, there is a SR trade-off between the inflation & unemployment rates
AS shocks can cause both higher rates of inflation & higher rates of unemployment
No significant tradeoff between inflation & unemployment over long periods of time
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11. Phillips Curve
Demonstrates the SR trade-off between the inflation & unemployment rates
Inverse relationship between the two
I.E. lower unemployment rates are associated with higher rates of inflation
Figure 15.6…Data points from the 1960’s seemed to confirm the Phillips Curve concept
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12. SR effect of changes in AD on real output & price level
The larger the increase in AD, the higher the inflation rate & the greater increase in real output.
Real output & unemployment move in opposite directions
High inflation rates should be accompanied by low rates of unemployment
Figure 15.7…shifts in AD lead to inflation & increase in output which decreases unemployment
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13. AS Shocks & the Phillips Curve
Unemployment-inflation experience of the 1970’s & early 1980’s ruined the idea of an always-stable Phillips Curve.
Inflation & unemployment rose simultaneously (stagflation)
Adverse AS Shocks
Sudden, large increases in resource costs (I.E. crude oil) that shift the SR AS to the left
Causes stagflation
Stagflation’s demise
From , there was an inward movement of the inflation-unemployment points (many wage & price reductions during this period)
Led to lower Inflation & unemployment rates
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14. Misery Index Sum of nation’s unemployment & inflation rates
Measure of national economic discomfort
When this figure rises during an election year, the incumbent political party struggles to get re-elected
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15. The Long-Run Phillips Curve
The overall set of data points on the Phillips Curve show that there is no apparent long-run tradeoff between inflation & unemployment
Short-Run Phillips Curve
Increases in AD may temporarily boost profits, output, & employment (a1 to b1)
Wages will catch up, profits will eventually fall. Move from b1 to a2 (new phillips curve)
2&3 use figure 15.9
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16. Long-Run Vertical Phillips Curve
Vertical line through a1, a2, & a3 shows the LR relationship between inflation & unemployment
Point b1 is not a stable equilibrium
Wages will increase to restore lost purchasing power
Business profits will fall to their prior level
Unemployment will rise but inflation will not change
Disinflation - Reductions in inflation from year to year
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17. Taxation and Aggregate Supply
Supply-side economics (supply-siders)
Changes in AS are an active force in determining the levels of inflation, unemployment, & economic growth
Government policies can either impede or promote rightward shifts of the SR & LR AS curves
Taxes & incentives to work
Enlargement of the U.S. tax system has impaired incentives to work, save, & invest
High tax rates impede productivity growth & slow the expansion of LR AS.
Supply-siders believe that how long & hard people work depends on the amounts of additional after-tax earnings they get for their efforts
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18. Incentives to save & invest
High tax rates reduce the rewards for saving & investing.
Lower tax rates encourage saving & investing
Workers find themselves equipped with more & technologically superior machinery & equipment
Labor productivity rises
LRAS will expand and economy will grow as well
Unemployment & inflation rates will be low
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19. The Laffer Curve
Shows the relationship between tax rates & tax revenues
Up to point m, higher tax rates will result in larger tax revenues
Tax rates higher than m will adversely affect incentives to work & produce reducing the size of the tax base
Criticisms
Taxes, incentives, & time – Does lower taxes really make people want to work harder?
Inflation or higher real interest rates – tax cuts may cause demand-pull inflation
Position on the curve
Figure 15.10
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