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Extending the Analysis of Aggregate Supply Chapter 18 5/23/2017 1 From Short Run to Long Run Short-Run 5/23/2017 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 2 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 5/23/2017 3 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 5/23/2017 4 Long-Run AS A rise in the price level results in higher nominal wages Decrease in price level reduces nominal wages AS curve shifts to left AS curve shifts to right After such adjustments, the economy obtains equilibrium at a different point on the curve 5/23/2017 LR AS curve is vertical 5 Long-Run Equilibrium in the AD-AS Model SRAS curve adjusts After those adjustments, long-run equilibrium occurs where all three curves intersect 5/23/2017 6 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 5/23/2017 7 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 5/23/2017 8 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) 5/23/2017 9 The Inflation-Unemployment Relationship Important because low inflation & unemployment are major economic goals. Are they compatible or conflicting? Three generalizations 1. Under normal circumstances, there is a SR trade-off between the inflation & unemployment rates 2. AS shocks can cause both higher rates of inflation & higher rates of unemployment 3. No significant tradeoff between inflation & unemployment over long periods of time 5/23/2017 10 Phillips Curve Demonstrates the SR trade-off between the inflation & unemployment rates Inverse relationship between the two 5/23/2017 I.E. lower unemployment rates are associated with higher rates of inflation 11 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 5/23/2017 12 AS Shocks & the Phillips Curve Unemployment-inflation experience of the 1970’s & early 1980’s ruined the idea of an always-stable Phillips Curve. Adverse AS Shocks Inflation & unemployment rose simultaneously (stagflation) Sudden, large increases in resource costs (I.E. crude oil) that shift the SR AS to the left Causes stagflation Stagflation’s demise From 1982-89, there was an inward movement of the inflationunemployment points (many wage & price reductions during this period) 5/23/2017 Led to lower Inflation & unemployment rates 13 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 5/23/2017 14 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 5/23/2017 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) 15 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 5/23/2017 16 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 5/23/2017 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 17 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 5/23/2017 Labor productivity rises LRAS will expand and economy will grow as well Unemployment & inflation rates will be low 18 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 5/23/2017 Taxes, incentives, & time – Does lower taxes really make people want to work harder? Inflation or higher real interest rates – tax cuts may cause demandpull inflation Position on the curve 19