CHAPTER 16CHAPTER 16

• Analysis of AS curveAnalysis of AS curve

• Phillips curvePhillips curve

• Supply shocksSupply shocks

• Laffer curvesLaffer curves

SHORT-RUN AND LONG-RUNAGGREGATE SUPPLY

Period in which nominal wages (and other input prices) remainfixed as the price level increases or decreases

Short Run -

Period in which nominal wages are fully responsive to previous changes in the price level

Long Run -

AGGREGATE SUPPLYAGGREGATE SUPPLY

• Usually assume it is stableUsually assume it is stable

• IN REALITY:IN REALITY:– IF PRICE AND OUTPUT INCREASES---IF PRICE AND OUTPUT INCREASES---

•WORKERS NEED MORE $ TO BUY THINGSWORKERS NEED MORE $ TO BUY THINGS

•NOMINAL WAGES INCREASE TO RESTORE NOMINAL WAGES INCREASE TO RESTORE PURCHASING POWERPURCHASING POWER

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

3 ASSUMPTIONS OF SR AS3 ASSUMPTIONS OF SR AS

• 1-PRICE LEVEL SET1-PRICE LEVEL SET

• 2-NOMINAL WAGES SET2-NOMINAL WAGES SET

• 3-PRICE IS FLEXIBLE UP AND DOWN3-PRICE IS FLEXIBLE UP AND DOWN

o

AS1

P1

P2

Qf Q2

a1

a2

A higher price level increases profits and output moving the economy from a1 to a2.

Pri

ce L

evel

Real domestic output

SHORT-RUN AGGREGATE SUPPLY

o

AS1

P1

P2

Qf

a1

a2

A lower price level decreases profits and output moving the economy from a1 to a3 .

Pri

ce L

evel

Real domestic output

SHORT-RUN AGGREGATE SUPPLY

P3 a3

Q2Q3

o

AS1

P1

P2

Qf

a2

a1

AS2

b1

ASLR

Pri

ce L

evel

Real domestic output

LONG-RUN AGGREGATE SUPPLYA higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left .

o

P3

AS1

P1

P2

Qf

a2

a3

a1

AS2

b1

AS3

c1

ASLR

Pri

ce L

evel

Real domestic output

LONG-RUN AGGREGATE SUPPLYA lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right .

DIFFERENCES BETWEEN SR DIFFERENCES BETWEEN SR & LR& LR• SR ASSR AS

• NOMINAL WAGES NOMINAL WAGES STAY SAME AS STAY SAME AS PRICE CHANGESPRICE CHANGES

• COLA CLAUSES & COLA CLAUSES & RAISES TAKE TIMERAISES TAKE TIME

• LRASLRAS

• VERTICAL LINEVERTICAL LINE

• NOMINAL WAGES NOMINAL WAGES EVENTUALLY EVENTUALLY CHANGE BY THE CHANGE BY THE SAME AMOUNT AS SAME AMOUNT AS PRICE LEVELPRICE LEVEL

EQUILIBRIUM IN THEEXTENDED AD-AS MODEL

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

DEMAND-PULL INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

P3

AD2

AS2

c

Q1

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

AS2

Occurs when short-run AS shifts left

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

AS2

If government allows a recession to occur

Q2

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

P3

AD2

AS2

Government response with increased AD

c

Evenhigherpricelevels

Effect of Changes in AD Effect of Changes in AD on Real Output and Price Levelon Real Output and Price Level

o

PLPL11

YY11

ADAD11

ASASsrsr

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

ADAD22

PLPL22

YY22

ADAD33

PLPL33

YY33

Inflation-Unemployment RelationshipInflation-Unemployment Relationship

• Normally, there is a short-run trade-off Normally, there is a short-run trade-off between the rate of inflation and the the between the rate of inflation and the the rate of unemployment caused by changes in rate of unemployment caused by changes in AD.AD.• AS shocks causeAS shocks cause• higher rates of inflationhigher rates of inflation• higher rates of unemployment.higher rates of unemployment.

• There is no significant trade-off over long There is no significant trade-off over long periods of time.periods of time.

An

nu

al r

ate

of in

flat

ion

An

nu

al r

ate

of in

flat

ion

Unemployment rate (percent)Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

As As inflation declines...inflation declines...

The Phillips Curve ConceptThe Phillips Curve ConceptThe Phillips Curve ConceptThe Phillips Curve Concept

UnemploymentUnemploymentincreasesincreases

PCPC

The Phillips Curve Trade-OffThe Phillips Curve Trade-Off

UNEMPLOYMENT RATE

INF

LA

TIO

N R

AT

E

REAL OUTPUT

PR

ICE

LE

VE

L

√ √ Increases in AD causes movements along the Increases in AD causes movements along the Phillips Curve. Phillips Curve. √ √ As AD changes, the tradeoff between rate of As AD changes, the tradeoff between rate of inflation and rate of unemployment moves to a inflation and rate of unemployment moves to a new position on PC.new position on PC.

BB

CCADAD11

ADAD22

AA

ADAD33 Phillips curvePhillips curve

CC

BB

AA

ASAS PCPC

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

The Phillips Curve Trade-The Phillips Curve Trade-OffOffShort RunShort Run

SummarySummary

Phillips Curve in the 1960sPhillips Curve in the 1960s

Phillips Curve Shifting in the 70s and 80sPhillips Curve Shifting in the 70s and 80s

Phillips Phillips “Curl”“Curl”

UnemploymentUnemployment got worse but

so did inflation.inflation.

Adverse supply shocks can cause periods of rising Adverse supply shocks can cause periods of rising unemployment and rising inflation. Rapid and unemployment and rising inflation. Rapid and

significant increases in resource prices push significant increases in resource prices push Aggregate Supply to the left. Aggregate Supply to the left.

Aggregate Supply and Shifting ViewsAggregate Supply and Shifting ViewsAggregate Supply and Shifting ViewsAggregate Supply and Shifting Views

o

PLPL11

YY11

ADAD11

ASASsrsr

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

PLPL22

YY22

PLPL33

YY33

ASAS22srsr

ASAS33srsr

HISTORICAL EVIDENCEHISTORICAL EVIDENCE

• OPEC OIL INCREASES IN THE 70’S +OPEC OIL INCREASES IN THE 70’S +• AGRIC. PROBLEMS +AGRIC. PROBLEMS +• DEPRECIATION OF THE $ === RISE DEPRECIATION OF THE $ === RISE

IN WAGESIN WAGES• BUT—DECLINING PRODUCTIVITY AS BUT—DECLINING PRODUCTIVITY AS

JAPAN BECOMES AN ECON POWER & JAPAN BECOMES AN ECON POWER & THE US ISN’TTHE US ISN’T

• ==== STAGFLATION==== STAGFLATION

1980’S & 1990’S1980’S & 1990’S

• HIGH UNEMPLOYMENT---LOWER HIGH UNEMPLOYMENT---LOWER WAGE INCREASES (OR NONE) +WAGE INCREASES (OR NONE) +

• FOREIGN COMPETITION ==== FOREIGN COMPETITION ==== HOLDS DOWN PRICES & WAGESHOLDS DOWN PRICES & WAGES

• DEREGULATION (AIR/PHONE ETC) + DEREGULATION (AIR/PHONE ETC) + DECLINE OF OPEC === SR AS DECLINE OF OPEC === SR AS SHIFTED BACK AND LRAS ADJUSTSSHIFTED BACK AND LRAS ADJUSTS

Changes in AS move the Phillips CurveChanges in AS move the Phillips Curve

o

PLPL11

YY11

ADAD11

ASASsrsr

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

PLPL22

YY22

PLPL33

YY33

ASAS22srsr

ASAS33srsr

An

nual

rat

e of

infl

atio

nA

nnu

al r

ate

of in

flat

ion

Unemployment rate (percent)Unemployment rate (percent)

77

66

55

44

33

22

11

001 2 3 4 5 6 71 2 3 4 5 6 7

PCPC11

PCPC22

PCPC33

15%15%SSRRPPCC33

SSRRPPCC11

SSRRPPCC22

aa11

aa22

aa33

bb11

bb22

bb33

PC1PC1

PCPC22

PCPC33

LRPCLRPC

Inflat.Inflat.GapGap

Recess.Recess.GapGap

Infl

atio

n R

ate

Infl

atio

n R

ate

Unemployment RateUnemployment Rate

12%12%

9%9%

6%6%

3%3%

002%2% 4%4% 6%6% 8%8% 10%10%

Phillips Curve Long RunPhillips Curve Long RunAD changes AD changes move move alongalong the Philllips the Philllips CurveCurve

AS changes AS changes move the move the Phillips Phillips Curve Curve

1. Increases in AD beyond full employment temporarily boost 1. Increases in AD beyond full employment temporarily boost

profits, output and employment. (aprofits, output and employment. (a11 to b to b11).).

2. Nominal wages eventually catch up to sustain real wages; 2. Nominal wages eventually catch up to sustain real wages;

profit fall, canceling the short-run effect with employment profit fall, canceling the short-run effect with employment

returning to its full employment level.(breturning to its full employment level.(b11 to a to a22), but at higher ), but at higher

inflation.inflation.

3. The cycle starts again as AD grows, profits grow and 3. The cycle starts again as AD grows, profits grow and

employment rises (aemployment rises (a22 to b to b22))

4. Again, in time, nominal wages catch up and employment 4. Again, in time, nominal wages catch up and employment

returns to its natural rate. The reward is a higher inflation rate. returns to its natural rate. The reward is a higher inflation rate.

Phillips Curve Long RunPhillips Curve Long Run

√ √ There is not a stable relationship between unemployment and There is not a stable relationship between unemployment and

inflation as shown.inflation as shown.

√ √ The long-run Phillips curve is the vertical line through aThe long-run Phillips curve is the vertical line through a11, a, a22, ,

and aand a3 3 at the natural rate of unemployment.at the natural rate of unemployment.

√ √ Any rate of inflation is consistent with the 5% natural rate of Any rate of inflation is consistent with the 5% natural rate of

unemployment. unemployment.

√ √ After all nominal wage adjustments to increases or decreases After all nominal wage adjustments to increases or decreases

in inflation have occurred, the economy ends up back at full-in inflation have occurred, the economy ends up back at full-

employment natural rate position.employment natural rate position.

The Phillips Curve —Long The Phillips Curve —Long RunRun

SummarySummary

0

100

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m

n

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m m

n

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

MaximumTax

Revenue

SUPPLY SIDE ECONOMICSSUPPLY SIDE ECONOMICS

• AS is what determines inflation, growth and AS is what determines inflation, growth and unemploymentunemployment

• High tax rates----hurt productivityHigh tax rates----hurt productivity– Also: discourage econ activityAlso: discourage econ activity– Tax evasionTax evasion

• Low tax rates (for businesses) encourage Low tax rates (for businesses) encourage investmentinvestment– Encourage work, savingsEncourage work, savings– Rewards for consumers who save decreases with higher Rewards for consumers who save decreases with higher

marginal tax ratesmarginal tax rates– Encourage people to enter labor force reducing Encourage people to enter labor force reducing

unemploymentunemployment– Increasing productivityIncreasing productivity– AS expands and keeps inflation lowAS expands and keeps inflation low

CRITICISMS OF THE LAFFER CRITICISMS OF THE LAFFER CURVECURVE

• Economic incentives don’t have as Economic incentives don’t have as large an impactlarge an impact

• If decrease taxes when close to If decrease taxes when close to peak----get inflation thru increased peak----get inflation thru increased ADAD

• 1980’s—Reaganomics—proves Laffer 1980’s—Reaganomics—proves Laffer curve correct with some exceptionscurve correct with some exceptions