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Long-run Macroeconomic Adjustments
CHAPTER 14
LONG-RUN MACROECONOMIC
ADJUSTMENTS
CHAPTER OVERVIEW
This first chapter of Part IV goes into more details on the difference between long-run and short-run
aggregate supply; it examines the unemployment-inflation relationship and assesses the effect of taxes on
aggregate supply.
WHAT’S NEW
Most of the organization and content of this chapter remains unchanged.
The definition of the short run has been changed slightly from a period of “fixed nominal wages” to a
period in which “wages do not respond to price level changes,” making it consistent with new language in
Chapter 8.
A “Consider This” box on “Bank of Canada and the Phillips Curve” has been added.
The “Last Word” on the “Impact of Oil” has been revised and updated. Also, a new Web-Based Question
on “dynamic tax scoring” has been added.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to understand:
1.
2.
3.
4.
To apply the long-run AD-AS model to explain inflation, recessions, and unemployment.
About the inflation-unemployment relationship.
The long-run Phillips Curve.
About the effects of taxation on aggregate supply.
COMMENTS AND TEACHING SUGGESTIONS
1.
The Phillips curve controversy can be introduced by using actual data such as those shown in
Figure 14-5b. Ask students if they can see any discernible pattern between unemployment and
inflation rates without the curves shown.
2.
The aggregate supply and demand model can also be helpful in explaining why demand
management policies might entail supply-side effects that limit the attainment of policy goals. The
shifts in Figure 14-4 should be carefully described to illustrate this problem.
3.
Demand-pull and cost-push inflation were introduced earlier, so they should be familiar to students.
However, a review of the aggregate demand and supply model would be a useful way to begin the
discussion. Explain that it is difficult to distinguish the two types of inflation in the real world,
since the causes of inflation are complex. Use Figures 14-1 and 14-2 to illustrate.
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Long-run Macroeconomic Adjustments
4.
A speaker who can recall a period of wage–price controls and the problems associated with them
might be interesting for students, who might otherwise believe these controls are a simple solution.
5.
Throughout the discussion of the Phillips curve, be sure to point out that the vertical axis measures
changes in the price level, not the price level itself (as in AD-AS model).
STUDENT STUMBLING BLOCKS
1.
Students may have trouble understanding why employment declines when policies to reduce
inflation are implemented.
2.
Students may have difficulty with the long-run AD-AS model. Have them review Figure 8-11
carefully. Use current events to give them practice deciding how the event will affect the economy,
through the demand side or the supply side.
LECTURE NOTES
I.
Introduction
A. Recent focus on the long-run adjustments and economic outcomes has renewed debates about
stabilization policy and causes of instability.
B. This chapter makes the distinction between short-run and long-run aggregate supply.
C. The extended model is then used to glean new insights on demand-pull and cost-push
inflation.
D. The relationship between inflation and unemployment is examined; we look at how
expectations can affect the economy, and assess the effect of taxes on aggregate supply.
II.
Applying the Long-run AD-AS Model
A. Demand-pull inflation: In the short run it drives up the price level and increases real output;
in the long run, only price level rises. (See Figure 14-1)
B. Cost push inflation arises from factors that increase the cost of production at each price level;
the increase in the price of a key resource, for example. This shifts the short run supply to the
left, not as a response to a price level increase, but as its initiating cause. Cost-push inflation
creates a dilemma for policymakers. (See Figure 14-2)
1. If government attempts to maintain full employment when there is cost-push inflation an
inflationary spiral may occur.
2. If government takes a hands-off approach to cost push inflation, a recession will occur.
The recession may eventually undo the initial rise in per unit production costs, but in the
meantime unemployment and loss of real output will occur.
C. Recession and the long-run AD-AS model.
1. When aggregate demand shifts leftward a recession occurs. If prices and wages are
downwardly flexible, the price level falls. The decline in the price level reduces nominal
wages, which then eventually shifts the aggregate supply curve to the right. The price
level declines and output returns to the full employment level. (See Figure 13-3)
2. This is the most controversial application of the long-run AD-AS model. The key point
of dispute is how long it would take in the real world for the necessary price and wage
adjustments to take place to achieve the indicated outcome.
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Long-run Macroeconomic Adjustments
III.
The Phillips Curve and the Inflation – Unemployment Tradeoff
A. Both low inflation and low unemployment are major goals. But are they compatible?
B. The Phillips Curve is named after A.W. Phillips, who developed his theory in Great Britain
by observing the British relationship between unemployment and wage inflation.
C. The basic idea is that given the short run aggregate supply curve, an increase in aggregate
demand will cause the price level to increase and real output to expand, and the reverse for a
decrease in AD. (Figure 14-5)
D. This tradeoff between output and inflation does not occur over long time periods.
E. Empirical work in the 1960s verified the inverse relationship between the unemployment rate
and the rate of inflation in Canada for 1961-1969. (See Figure 14-5b)
F. The stable Phillips Curve of the 1960s gave way to great instability of the curve in the 1970s
and 1980s. The obvious inverse relationship of 1961-1969 had become obscure and highly
questionable. (See Figure 14-6)
1. In the 1970s the economy experienced increasing inflation and rising unemployment:
stagflation.
2. At best, the date in Figure 14-6 suggests a less desirable combination of unemployment
and inflation. At worse, the data imply no predictable trade off between unemployment
and inflation.
G. Adverse aggregate supply shocks—the stagflation of the 1970s and early 1980s may have
been caused by a series of adverse aggregate supply shocks. (Rapid and significant increases
in resource costs.)
1. The most significant of these supply shocks was a quadrupling of oil prices by the
Organization of Petroleum Exporting Countries (OPEC).
2. Other factors included agricultural shortfalls, a greatly depreciated dollar, wage increases
and declining productivity.
3. Leftward shifts of the short run aggregate supply curve make a difference. The Phillips
Curve trade off is derived from shifting the aggregate demand curve along a stable shortrun aggregate supply curve. (See Figure 14-6)
4. The “Great Stagflation” of the 1970s made it clear that the Phillips Curve did not
represent a stable inflation/unemployment relationship.
H. Global Perspective 14-1 portrays the “misery index” in 1999-2002 for several nations. The
index adds unemployment and inflation rates.
IV.
Long-Run Vertical Phillips Curve
A. This view is that the economy is generally stable at its natural rate of unemployment (or fullemployment rate of output).
1. The hypothesis questions the existence of a long-run inverse relationship between the rate
of unemployment and the rate of inflation.
2. Figure 14-7 explains how a short-run tradeoff exists, but not a long-run tradeoff.
3. In the short run we assume that people form their expectations of future inflation on the
basis of previous and present rates of inflation and only gradually change their
expectations and wage demands.
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Long-run Macroeconomic Adjustments
4. Fully anticipated inflation by labor in the nominal wage demands of workers generates a
vertical Phillips Curve. (See Figure 14-7) This occurs over time.
B. Interpretations of the Phillips Curve have changed dramatically over the past three decades.
1. The original idea of a stable tradeoff between inflation and unemployment has given way
to other views that focus more on long-run effects.
2. Most economists accept the idea of a short-run tradeoff—where the short run may last
several years—while recognizing that in the long run such a tradeoff is much less likely.
V.
Taxation and Aggregate Supply
A. Economic disturbances can be generated on the supply side, as well as on the demand side of
the economy. Certain government policies may reduce the growth of aggregate supply.
“Supply-side” economists advocate policies that promote output growth. They argue that:
1. The tax transfer system has negatively affected incentives to work, invest, innovate and
assume entrepreneurial risks.
a. To induce more work government should reduce marginal tax rates on earned
income.
b. Unemployment compensation and welfare programs have made job loss less of an
economic crisis for some people. Many transfer programs are structured to
discourage work.
2. The rewards for saving and investing have also been reduced by high marginal tax rates.
A critical determinant of investment spending is the expected after-tax return.
3. Lower marginal tax rates may encourage more people to enter the labor force and to work
longer. The lower rates should reduce periods of unemployment and raise capital
investment, which increases worker productivity. Aggregate supply will expand and
keep inflation low.
B. The Laffer Curve is an idea relating tax rates and tax revenues. It is named after economist
Arthur Laffer, who originated the theory. (See Figure 14-8)
1. As tax rates increase from zero, tax revenues increase from zero to some maximum level
(m) and then decline.
2. Tax rates above or below this maximum rate will cause a decrease in tax revenue.
3. Laffer argued that tax rates were above the optimal level and by lowering tax rates
government could increase the tax revenue collected.
4. The lower tax rates would trigger an expansion of real output and income enlarging the
tax base. The main impact would be on supply rather than aggregate demand.
C. Supply side economists offer two additional reasons for lowering the tax rate.
1. Tax avoidance (legal) and tax evasion (illegal) both decline when taxes are reduced.
2. Reduced transfers—tax cuts stimulate production and employment, reducing the need for
transfer payments such as welfare and unemployment compensation.
D. Criticisms of the Laffer Curve.
1. There is empirical evidence that the impact on incentives to work, save and invest are
small.
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Long-run Macroeconomic Adjustments
2. Tax cuts also increase demand, which can fuel inflation. Demand impact exceeds supply
impact.
3. The Laffer Curve is based on a logical premise, but where the economy is located is an
empirical question and difficult to determine. It may be hard to know in advance the
impact of a tax cut on supply.
VI.
LAST WORD: Has the Impact of Oil Prices Diminished?
A. Oil price changes have caused numerous (supply-side) shocks to the Canadian economy. The
worst (in terms of impact) occurred in the mid-1970s, and “reverse” shocks in the late 1980s
and 1990s actually benefited the Canadian macroeconomy.
B. Output restrictions beginning in 1999 raised oil prices significantly (up to US$34 a barrel),
igniting fear that cost-push inflation and inflation would occur. It didn’t for several reasons.
1. The adverse shock was offset by positive supply shocks such as increased productivity.
2. Oil prices and consumption have declined in relative importance to the overall Canadian
price level and production.
3. The Bank of Canada policy has pursued and maintained price stability with greater effort
and success than in the 1970s.
ANSWERS TO END-OF-CHAPTER QUESTIONS
14-1
(Key Question) Use graphical analysis to show how each of the following would affect the
economy first in the short run and then in the long run. Assume that Canada is initially operating
at its full employment level of output, that prices and wages are eventually flexible both upward
and downward, and that there is no counteracting fiscal or monetary policy.
a. Because of a war abroad, the oil supply to Canada is disrupted, sending oil prices rocketing
upward.
b. Construction spending on new homes rises dramatically, greatly increasing total Canadian
investment spending.
c. Economic recession occurs abroad, significantly reducing foreign purchases of Canadian
exports.
(a) See Figure 14-2 in the chapter. Short run: The aggregate supply curve shifts to the left, the
price level rises, and real output declines. Long run: The aggregate supply curve shifts back
rightward (due to declining nominal wages), the price level falls, and real output increases.
(b) See Figure 14-2. Short run: The aggregate demand curve shifts to the right, and both the price
level and real output increase. Long run: The aggregate supply curve shifts to the left (due to
higher nominal wages), the price level rises, and real output declines.
(c) See Figure 14-3. Short run: The aggregate demand curve shifts to the left, both the price level
and real output decline. Long run: The aggregate supply curve shifts to the right, the price
level falls further, and real output increases.
14-2
Assume that a particular short-run aggregate supply curve exists for an economy and that the
curve is relevant for several years. Use the AD-AS analysis to show graphically why higher rates
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of inflation over this period would be associated with lower rates of unemployment, and vice
versa. What is the inverse relationship called?
As aggregate demand increases given a particular short-run aggregate supply curve, increases in
real output are associated with increases in the price level. When real output increases, the
unemployment rate decreases. The Phillips curve shown on the right expresses the same
relationship as the AD-AS model, but graphs as an inverse relationship because unemployment is
on the horizontal axis rather than real output.
Question 14-2
-2
Phillips
curve
14.3
(Key Question) Suppose the government misjudges the natural rate of unemployment to be much
lower than it actually is, and thus undertakes expansionary fiscal and monetary policy to try to
achieve the lower rate. Use the concept of the short-run Phillips Curve to explain why these
policies might at first succeed. Use the concept of the long-run Phillips Curve to explain the
long-run outcome of these policies.
In the short-run there is probably a tradeoff between unemployment and inflation. The
government’s expansionary policy should reduce unemployment as aggregate demand increases.
However, the government has misjudged the natural rate and will continue its expansionary
policy beyond the point of the natural level of unemployment. As aggregate demand continues to
rise, prices begin to rise. In the long-run, workers demand higher wages to compensate for these
higher prices. Aggregate supply will decrease (shift leftward) toward the natural rate of
unemployment.
In other words, any reduction of unemployment below the natural rate is only temporary and
involves a short-run rise in inflation. This, in turn, causes long-run costs to rise and a decrease in
aggregate supply. The end result should be an equilibrium at the natural rate of unemployment
and a higher price level than the beginning level. The long-run Phillips curve is thus a vertical
line connecting the price levels possible at the natural rate of unemployment found on the
horizontal axis.
14-4
What do the distinctions between short-run and long-run aggregate supply have in common with
the distinction between the short-run and long-run Phillips Curves? Explain.
In the short-run, economists assume that production costs don’t change so the aggregate supply
curve is fixed. Therefore, changes in aggregate demand are the sole determinant of
unemployment and inflation rates. In the long-run, wages and input prices adjust to price changes
causing rise (or fall) in production costs and aggregate supply decreases (or increases). This
means the long-run relationship between price-level and output is vertical at the full-employment
level of output.
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The long-run Phillips curve illustrates this latter point with the natural rate of unemployment
(sometimes called full-employment rate) being measured on the horizontal axis and price level on
the vertical axis. The long-run curve is vertical as shown in Figure 14-7. However, the short-run
Phillips curve reflects what happens with unemployment at different price levels using the shortrun aggregate supply curve.
14-5
(Key Question) What is the Laffer Curve and how does it relate to supply side economics? Why
is determining the location where the economy is on the curve so important in assessing tax
policy?
Economist Arthur Laffer observed that tax revenues would obviously be zero when the tax rate
was either at 0% or 100%. In between these two extremes would have to be an optimal rate
where aggregate output and income produced the maximum tax revenues. This idea is presented
as the Laffer Curve shown in Figure 14-8.
The difficult decision involves the analysis to determine what is the optimum tax rate for
producing maximum tax revenue and the related maximum economic output level. Laffer argued
that low tax rates would actually increase revenues because low rates improved productivity,
saving and investment incentives. The expansion in output and employment and thus, revenue,
would more than compensate for the lower rates.
14-6
Why might one person work more, earn more, and pay more income tax when his or her tax rate
is cut, while another person will work less, earn less, and pay less income tax under the same
circumstance?
Proponents of supply-side economics argue that cuts in the marginal tax rate on earned income
will make work more attractive because the opportunity cost of leisure is higher. Thus,
individuals choose to substitute work for leisure. Critics of supply-side reasoning contend that
workers are just as likely to reduce their efforts because the after-tax pay increases their ability to
“buy leisure.” They can meet their after tax income goals by working fewer hours.
14-7
(The Last Word) Do oil prices play a smaller role or large role in the Canadian economy today
compared to the 1970s and 1980s? Explain why or why not.
Changes in oil prices have a smaller impact today than in the 1970s and 1980s for several
reasons. First, the beneficial effects on cost reduction of technology improvements offset higher
energy costs. Second, the Federal Reserve has become better at maintaining overall price
stability through monetary policy. Third, energy costs are not as large a proportion of production
costs as they used to be. Experts estimate that the U.S. economy is one-third less sensitive to oil
price changes than in early 1980s.
Consider This
The Bank of Canada hinted that it might have to raise interest rates again. The overnight loans
rate stood at 3.25 in the spring of 2003. Go to
http://www.bankofcanada.ca/en/mpr/mpr_previous.htm and click on the Monetary Policy Report
summary for the end of 2003. Was the Bank of Canada right in predicting that growth would pick
up in 2003? What occurred to the rate of inflation and the overnight loans during the course of
2003? Go to the Bank of Canada’s website to check on what occurred to growth rate of the
Canadian economy, the overnight loans rate and the rate of inflation during 2003.
Yes the Bank of Canada was right in its prediction that economic growth would pick up.
The rate of inflation moderated during the course of 2003. The overnight loans rate came down a
little over the course of 2003.
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