CHAPTER 16 Analysis of AS curve Analysis of AS curve Phillips curve Phillips curve Supply shocks...

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CHAPTER 16 CHAPTER 16 Analysis of AS curve Analysis of AS curve Phillips curve Phillips curve Supply shocks Supply shocks Laffer curves Laffer curves
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Transcript of CHAPTER 16 Analysis of AS curve Analysis of AS curve Phillips curve Phillips curve Supply shocks...

  • CHAPTER 16Analysis of AS curvePhillips curveSupply shocksLaffer curves

  • SHORT-RUN AND LONG-RUNAGGREGATE SUPPLYPeriod in which nominal wages (and other input prices) remainfixed as the price level increases or decreasesShort Run -Period in which nominal wages are fully responsive to previous changes in the price levelLong Run -

  • AGGREGATE SUPPLYUsually assume it is stableIN REALITY:IF PRICE AND OUTPUT INCREASES---WORKERS NEED MORE $ TO BUY THINGSNOMINAL WAGES INCREASE TO RESTORE PURCHASING POWER

    IN THE LONG RUN---LR AS changes because of changes in nominal wages

  • 3 ASSUMPTIONS OF SR AS1-PRICE LEVEL SET

    2-NOMINAL WAGES SET

    3-PRICE IS FLEXIBLE UP AND DOWN

  • oAS1P1P2QfQ2a1a2A higher price level increases profits and output moving the economy from a1 to a2.Price LevelReal domestic outputSHORT-RUN AGGREGATE SUPPLY

  • oAS1P1P2Qfa1a2A lower price level decreases profits and output moving the economy from a1 to a3 .Price LevelReal domestic outputSHORT-RUN AGGREGATE SUPPLYP3a3Q2Q3

  • oAS1P1P2Qfa2a1AS2b1ASLRPrice LevelReal domestic outputLONG-RUN AGGREGATE SUPPLYA higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left .

  • oP3AS1P1P2Qfa2a3a1AS2b1AS3c1ASLRPrice LevelReal domestic outputLONG-RUN AGGREGATE SUPPLYA lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right .

  • DIFFERENCES BETWEEN SR & LRSR ASNOMINAL WAGES STAY SAME AS PRICE CHANGESCOLA CLAUSES & RAISES TAKE TIMELRASVERTICAL LINENOMINAL WAGES EVENTUALLY CHANGE BY THE SAME AMOUNT AS PRICE LEVEL

  • EQUILIBRIUM IN THEEXTENDED AD-AS MODELoP1AS1ASLRAD1aQfPrice LevelReal domestic output

  • DEMAND-PULL INFLATIONoP1AS1ASLRAD1aQfPrice LevelReal domestic outputbP2P3AD2AS2cQ1

  • Q2COST-PUSH INFLATIONoP1AS1ASLRAD1aQfPrice LevelReal domestic outputbP2AS2Occurs when short-run AS shifts left

  • COST-PUSH INFLATIONoP1AS1ASLRAD1aQfPrice LevelReal domestic outputbP2AS2If government allows a recession to occurQ2

  • Q2COST-PUSH INFLATIONoP1AS1ASLRAD1aQfPrice LevelReal domestic outputbP2P3AD2AS2Government response with increased ADcEvenhigherpricelevels

  • Effect of Changes in AD on Real Output and Price LeveloPL1Y1AD1ASsrPrice LevelReal domestic outputAD2PL2Y2AD3PL3Y3

  • Inflation-Unemployment RelationshipNormally, there is a short-run trade-off between the rate of inflation and the the rate of unemployment caused by changes in AD.AS shocks causehigher rates of inflationhigher rates of unemployment.There is no significant trade-off over long periods of time.

  • Annual rate of inflationUnemployment rate (percent)7

    6

    5

    4

    3

    2

    1

    01 2 3 4 5 6 7As inflation declines...The Phillips Curve ConceptUnemploymentincreasesPC

  • The Phillips Curve Trade-Off Increases in AD causes movements along the Phillips Curve. As AD changes, the tradeoff between rate of inflation and rate of unemployment moves to a new position on PC.BCAD1AD2AAD3Phillips curveCBAASPC

  • In the short run, changes in aggregate demand are movements along the short-run aggregate supply curve. If Aggregate Demand moves upward, price level rises and Real GDP rises and is reflected as a new point on the short-run Phillips curve showing higher rate of inflation and higher unemployment. If AD moves down, price level falls and Real GDP falls and is reflected as a new point on the short-run Phillips curve showing lower rate of inflation and lower unemployment. The Phillips Curve Trade-OffShort RunSummary

  • Phillips Curve in the 1960s

  • Phillips Curve Shifting in the 70s and 80s

  • Phillips CurlUnemployment got worse but so did inflation.

  • Adverse supply shocks can cause periods of rising unemployment and rising inflation. Rapid and significant increases in resource prices push Aggregate Supply to the left. Aggregate Supply and Shifting Views

  • HISTORICAL EVIDENCEOPEC OIL INCREASES IN THE 70S +AGRIC. PROBLEMS +DEPRECIATION OF THE $ === RISE IN WAGESBUTDECLINING PRODUCTIVITY AS JAPAN BECOMES AN ECON POWER & THE US ISNT==== STAGFLATION

  • 1980S & 1990SHIGH UNEMPLOYMENT---LOWER WAGE INCREASES (OR NONE) +FOREIGN COMPETITION ==== HOLDS DOWN PRICES & WAGESDEREGULATION (AIR/PHONE ETC) + DECLINE OF OPEC === SR AS SHIFTED BACK AND LRAS ADJUSTS

  • Changes in AS move the Phillips Curve

  • 15%SRPC3SRPC1SRPC2a1a2a3b1b2b3PC1PC2PC3LRPCInflat.GapRecess.GapInflation RateUnemployment Rate12%9%6%3%02%4%6%8%10%Phillips Curve Long RunAD changes move along the Philllips CurveAS changes move the Phillips Curve

  • 1. Increases in AD beyond full employment temporarily boost profits, output and employment. (a1 to b1).2. Nominal wages eventually catch up to sustain real wages; profit fall, canceling the short-run effect with employment returning to its full employment level.(b1 to a2), but at higher inflation.3. The cycle starts again as AD grows, profits grow and employment rises (a2 to b2)4. Again, in time, nominal wages catch up and employment returns to its natural rate. The reward is a higher inflation rate. Phillips Curve Long Run

  • There is not a stable relationship between unemployment and inflation as shown. The long-run Phillips curve is the vertical line through a1, a2, and a3 at the natural rate of unemployment. Any rate of inflation is consistent with the 5% natural rate of unemployment. After all nominal wage adjustments to increases or decreases in inflation have occurred, the economy ends up back at full-employment natural rate position.The Phillips Curve Long RunSummary

  • 0100lTHE LAFFER CURVETax revenue (dollars)Tax rate (percent)

  • 0100mnlTHE LAFFER CURVETax revenue (dollars)Tax rate (percent)

  • 0100mmnlTHE LAFFER CURVETax revenue (dollars)Tax rate (percent)MaximumTaxRevenue

  • SUPPLY SIDE ECONOMICSAS is what determines inflation, growth and unemploymentHigh tax rates----hurt productivityAlso: discourage econ activityTax evasionLow tax rates (for businesses) encourage investmentEncourage work, savingsRewards for consumers who save decreases with higher marginal tax ratesEncourage people to enter labor force reducing unemploymentIncreasing productivityAS expands and keeps inflation low

  • CRITICISMS OF THE LAFFER CURVEEconomic incentives dont have as large an impactIf decrease taxes when close to peak----get inflation thru increased AD1980sReaganomicsproves Laffer curve correct with some exceptions