1. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 1 SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE Long-Run Macroeconomic Adjustments

2. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 2 In this chapter you will learn 14.1 To apply the long-run AD-AS model to explain inflation, recessions, and unemployment 14.2 About the inflation- unemployment relationship 14.3 The long-run Phillips Curve 14.4 About the effects of taxation on aggregate supply

3. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 3 Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

4. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 4 Applying the Long-Run AD- AS Model q Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level

5. Price Level Real domestic product o AS 1 Demand-Pull Inflation P1P1 GDP f The starting point is full employment GDP (GDP f ) AD 1 Figure 14-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 5

6. o AS 1 P1P1 Something causes AD to increase… what are some possibilities? AD 1 Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 6

7. o AS 1 P1P1 Higher demand leads to a higher price level, and higher output AD 1 P2P2 AD 2 GDP 2 Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 7

8. o AS 1 P1P1 AD 1 P2P2 AD 2 GDP 2 A higher price level (P 2 ) EVENTUALLY leads to higher nominal wages which causes.... Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 8

9. o AS 1 P1P1 P3P3 GDP 2 AD 2 A left shift of the short run AS curve AS 2 P2P2 AD 1 Demand-Pull Inflation Price Level GDP f Figure 14-1 Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 9

10. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 10 Demand-Pull Inflation q in the short run, demand-pull inflation drives up prices and output q in the long run, output is restored to GDP f and only the price level is higher

11. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 11 Cost-Push Inflation q Cost-push inflation arises from factors that increase the cost of production at each price level

12. o AS 1 P1P1 GDP f Something drives up production costs…such as? AD 1 Cost-Push Inflation Figure 14-2 Price Level AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 12

13. o AS 1 P1P1 AS shifts to the left, leading to higher prices and lower output AD 1 AS 2 P2P2 Price Level Cost-Push Inflation Figure 14-2 GDP 2 GDP f AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 13

14. o AS 1 P1P1 Now what? Left alone, the economy will eventually make its way back to GDP f AD 1 AS 2 P2P2 HOW? Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 14

15. o AS 1 P1P1 Layoffs, high unemployment will eventually lead to lower factor prices AD 1 AS 2 P2P2 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 15

16. o AS 1 P1P1 What other options are there? AD 1 AS 2 P2P2 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 16

17. o AS 1 P1P1 Expansionary fiscal or monetary policy AD 1 AS 2 P2P2 AD 2 P3P3 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 17

18. o AS 1 P1P1 But this leads to higher inflation AD 1 AS 2 P2P2 AD 2 P3P3 Price Level Cost-Push Inflation Figure 14-2 GDP f GDP 2 AS LR Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 18

19. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 19 Cost-Push Inflation q if government attempts to maintain full employment, an inflationary spiral may occur q otherwise, there will be a recession, with high unemployment and a loss of output

20. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 20 Recession & the Long-Run AD-AS Model q how long would it take in the real world for price & wage adjustments to occur, to regain full employment? q there is disagreement among economists about how long

21. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 21 Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

22. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 22 The Inflation-Unemployment Relationship q Under normal circumstances, there is a short-run tradeoff between inflation & unemployment q Aggregate supply shocks can cause both higher inflation & higher unemployment q There is no significant tradeoff between inflation & unemployment over long periods of time

23. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 23 The Phillips Curve q Assuming a constant AS, high rates of inflation are accompanied by low rates of unemployment, & vice-versa illustrated…

24. o P0P0 GDP 0 AS AD 0 The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 24

25. o P0P0 P1P1 GDP 0 GDP 1 AS AD 0 AD 1 The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 25

26. o P0P0 P1P1 P2P2 GDP 0 GDP 1 GDP 2 AS AD 0 AD 1 AD 2 The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 26

27. o P0P0 P1P1 P2P2 P3P3 GDP 0 GDP 1 GDP 2 GDP 3 AD 0 AD 1 AD 2 AD 3 AS The Phillips Curve Figure 14-4 Price Level Real domestic product © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 27

28. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 28 Phillips Curve Concept & Canadian Data Figure 14-5

29. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 29 The Phillips Curve q Modern economists reject the idea of a stable, predictable long-run Phillips Curve q They agree there is a short-run tradeoff between inflation & unemployment

30. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 30 Aggregate Supply Shocks & the Phillips Curve q In the late 1970s and early 1980s, the economy experienced stagflation

31. AdverseAggregateSupplyShocks

32. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 32 Adverse Aggregate Supply Shocks q OPEC and Energy Prices q Other shocks: –agricultural shortfalls –dollar depreciation –wage increases after wage-price controls lifted –declining productivity

33. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 33 A Shifting Phillips Curve? Figure 14-6

34. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 34 Stagflation’s Demise q by the late 80’s, 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

35. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 35 Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

36. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 36 The Long-Run Phillips Curve q There is no apparent long-run tradeoff between inflation & unemployment

37. Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) 0 3 6 9 12 15 The Long-Run Phillips Curve Figure 14-7 economy is at a 1 with unemployment at 5%, and inflation at 3%; suppose wages are set on the assumption of 3% inflation © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 37

38. Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) 0 3 6 9 12 15 The Long-Run Phillips Curve suppose AD increases & inflation increases to 6%; economy moves to b 1 b1b1 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 38

39. Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) 0 3 6 9 12 15 The Long-Run Phillips Curve but b 1 is not a stable equilibrium; workers will demand higher wages; economy moves to a 2 b1b1 a2a2 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 39

40. Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) 0 3 6 9 12 15 The Long-Run Phillips Curve Phillips Curve shifts upward from PC 1 to PC 2 b1b1 a2a2 PC 2 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 40

41. Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) 0 3 6 9 12 15 The Long-Run Phillips Curve scenario repeats if AD increases again b1b1 a2a2 PC 2 b2b2 a3a3 PC 3 so any rate of inflation is possible with the 5% natural rate of unemployment Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 41

42. Annual rate of inflation (percent) 3456 PC 1 a1a1 PC LR Unemployment rate (per cent) 0 3 6 9 12 15 The Long-Run Phillips Curve b1b1 a2a2 PC 2 b2b2 a3a3 PC 3 the long-run Phillips Curve is vertical at the 5% natural rate of unemployment Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 42

43. Annual rate of inflation (percent) 3456 PC LR Unemployment rate (per cent) a3a3 PC 3 0 3 6 9 12 15 c3c3 The Long-Run Phillips Curve what about disinflation? suppose the economy is at a 3 & AD declines Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 43

44. Annual rate of inflation (percent) 3456 PC LR Unemployment rate (per cent) a3a3 PC 3 0 3 6 9 12 15 c3c3 The Long-Run Phillips Curve firms & workers eventually adjust to lower 6% inflation PC 2 a2a2 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 44

45. Annual rate of inflation (percent) 3456 PC LR Unemployment rate (per cent) a3a3 PC 3 0 3 6 9 12 15 c3c3 The Long-Run Phillips Curve if AD falls further, the scenario will continue PC 2 a2a2 c2c2 PC 1 a1a1 Figure 14-7 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 45

46. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 46 Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply

47. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 47 Taxation & Aggregate Supply q Government policies can impede or promote rightward shifts of AS q Effects of taxation on the supply curve are key concerns of supply side economics

48. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 48 Taxes & Incentives to Work q Reductions in marginal tax rates on earned incomes induce more work q Lower marginal tax rates make leisure relatively more expensive

49. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 49 Incentives to Save & Invest q Lower marginal tax rates increase the rewards for saving & investing q Saving is a prerequisite for investment

50. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 50 The Laffer Curve q It is possible that reductions in marginal tax rates will increase AS but leave tax revenues unchanged illustrated…

51. Laffer Curve Tax revenue (dollars) 0 100 Shows impact of tax rates upon tax collections Tax rate (percent) Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 51

52. Laffer Curve Tax revenue (dollars) 0 100 Tax rate (percent) l increase tax rates and tax revenues increase Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 52

53. Laffer Curve Tax revenue (dollars) 0 100 m m Tax rate (percent) l tax revenues increase at a decreasing rate as rates rise further Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 53

54. Laffer Curve Tax revenue (dollars) 0 100 m m Tax rate (percent) n l at some point, rates are so high that economic activity decreases, and cheating increases Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 54

55. Laffer Curve Tax revenue (dollars) 0 100 m m Tax rate (percent) n l Figure 14-8 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 55

56. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 56 Criticisms of the Laffer Curve q Taxes, Incentives and Time –substitution effect as well as income effect q Inflation –demand side effects may be greater/quicker q Position on Curve –where are we?

57. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 57 Chapter 14 Topics 14.1 Applying the Long-Run AD-AS Model 14.2 The Inflation-Unemployment Relationship 14.3 The Long-Run Phillips Curve 14.4 Taxation & Aggregate Supply