Download Bringing in the supply-side

Chapter 10
Bringing in the Supply Side:
Unemployment and Inflation?
We might as well reasonably dispute whether it is the upper or the
under blade of a pair of scissors that cuts a piece of paper, as
whether value is governed by [demand] or [supply].
ALFRED MARSHALL
Why AS?
• Chapter 9 tells us change in AD will
create inflationary gap vs. recessionary
gap
• Which sort of gap will arise?
• Need to know price level
• AS + AD determine price level
• This chapter: bring the supply side back
The Aggregate Supply Curve
• Aggregate supply curve
– Each possible price level
– Quantity of goods & services
– All nation’s businesses - willing to produce
– Specified period of time
– All other determinants – constant
• Aggregate supply curve
– Slopes upward
3
Figure 1
An aggregate supply curve
Price Level
S
S
Real GDP
4
The AS Curve: Why Upward Slope?
• Unit profit = Price – Unit cost
• Aggregate supply curve - slopes upward
– Firms – purchase inputs
• Prices – fixed for some period of time
– Higher selling prices – output
• Production – more attractive
• Aggregate supply curve
– Shifts outward/right
– More output produced
• Any given price level
5
The Aggregate Supply Curve
• Aggregate supply curve
– Nominal wage rate – increase
• Higher real production costs
• Aggregate supply curve – shifts inward/left
– Prices of other inputs – increase
• Higher real production costs
• Aggregate supply curve – shifts inward/left
6
Figure 2
A shift of the aggregate supply curve
S1 (higher wages)
Price Level (P)
S0 (lower wages)
B
100
A
S1
S0
0
5,500
6,000
Real GDP (Y)
7
The Aggregate Supply Curve
• Aggregate supply curve
– Technology & productivity – improve
• Decrease business costs
• Aggregate supply curve – shift outward/right
– Available supply of labor & capital – better
• Labor force - grows or improves in quality
• Capital stock – increases (investment)
• Aggregate supply curve – shifts outward/right
8
Equilibrium: Aggregate Demand & Supply
• Equilibrium GDP
– AD curve intersects AS curve
– Equilibrium price level
– Equilibrium quantity
9
Figure 3
Equilibrium of real GDP and the price level
Price Level (P)
130
S
D
120
110
E
100
90
80
D
S
0
5,200 5,600 6,000 6,400 6,800
Real GDP (Y)
10
Equilibrium: Aggregate Demand & Supply
• For price level > Equilibrium price level
– Aggregate quantity supplied exceeds
• Aggregate quantity demanded
– Inventories – increase
• Prices – forced down
– Price level – falls
– Production – falls
11
Equilibrium: Aggregate Demand & Supply
• For price level < Equilibrium price level
– Aggregate quantity demanded exceeds
• Aggregate quantity supplied
– Shortage of goods
– Inventories – decrease
• Prices – increase
– Price level – rise
– Production – rise
12
Table 1
Determination of the equilibrium price level
(1)
(2)
(3)
(4)
(5)
Price
Level
Aggregate
Quantity
Demanded
Aggregate
Quantity
Supplied
Balance of Supply
and Demand
Prices will
be:
80
90
100
110
120
$6,400
6,200
6,000
5,800
5,600
$5,600
5,800
6,000
6,200
6,400
Demand exceeds supply
Demand exceeds supply
Demand equals supply
Supply exceeds demand
Supply exceeds demand
Rising
Rising
Unchanged
Falling
falling
13
Inflation and the Multiplier
• Aggregate supply curve – slopes upward
– Any increase in aggregate demand
• Price level – increase
• Erodes purchasing power of consumer wealth
• Reduces net exports
– Inflation – reduces value of multiplier
14
Figure 4
Inflation and the multiplier
D1
Price Level (P)
130
S
D0
E1
120
110
A
E0
100
$800
billion
90
D1
80
D0
S
0
6,000
6,400
Real GDP (Y)
6,800
15
Recessionary & Inflationary Gaps
• Recessionary gap
– Equilibrium GDP < Potential GDP
– Aggregate demand – weak
• Inflationary gap
– Equilibrium GDP > Potential GDP
– Excess aggregate demand
16
Figure 5 (a)
Recessionary and inflationary gaps revisited
Real Expenditure
Potential GDP
45°
C+I0+G+(X-IM)
E
B
Recessionary gap
Real GDP
Price Level
6,000 7,000
Potential GDP
S
D0
E
S
B
Recessionary gap
D0
0
6,000 7,000
17
Real GDP
Figure 5 (b)
Recessionary and inflationary gaps revisited
Real Expenditure
Potential GDP
E
45°
C+I1+G+(X-IM)
Real GDP
Price Level
7,000
Potential GDP
D1
S
E
S
D1
0
7,000
Real GDP
18
Figure 5 (c)
Recessionary and inflationary gaps revisited
Real Expenditure
Potential GDP
Inflationary
gap
B
45°
C+I2+G+(X-IM)
E
Price Level
7,000 8,000
Potential GDP
D2
E
Inflationary B
gap
S
Real GDP
S
D2
19
0
7,000 8,000
Real GDP
Adjusting to a Recessionary Gap
• Recessionary gap
 cyclical unemployment 
 wage 
 AS curve shifts outward
 Y, P
• It is a self-correcting mechanism
20
Figure 6
The elimination of a recessionary gap
Potential
GDP
S0
Price Level (P)
D
S1
E
100
B
F
S0
S1
Recessionary
gap
D
5,000 6,000
Real GDP (Y)
21
Adjusting to a Recessionary Gap
• In reality, wages & prices rarely fall
– Institutional factors: minimum wage law,
union contracts
– Psychological resistance to wage
reduction
– Business cycles – less severe
– Firms – don’t want to lose best employees
• Economy - get stuck
– Recessionary gap - long period
22
Adjusting to Inflationary Gap: Inflation
• Inflationary gap
 over employment
 wage 
 AS shifts inward
 Y, P
• Again, it is a self-correcting mechanism
23
Figure 7
The elimination of an inflationary gap
Potential
GDP
S1
D
Price Level (P)
F
B
S0
E
Inflationary
gap
S1
D
S0
Real GDP (Y)
24
Adjusting to Inflationary Gap: Inflation
• Self-correcting mechanism
– Takes time
• Stagflation
– Inflation and economic stagnation
– Normal – after excessive aggregate
demand
25
Stagflation from a Supply Shock
• Higher energy prices
– Aggregate supply – shift inward
– “Oil shocks”
• Adverse supply shocks
– Inward shift of aggregate supply
– Falling production
– Rising prices
26
Figure 8
Stagflation from an adverse shift in aggregate supply
Price Level
(2000=100)
S1
D
36.0
31.8
S0
A
E
D
S1
S0
4,275
Real GDP
4,342
27
Applying Model to a Growing Economy
• Simple model
– Aggregate demand
– Aggregate supply
– Equilibrium price level
– Equilibrium level of real GDP
• U.S. : price level & real GDP, 1972-2007
– Higher price level
– Higher GDP
– Growth & Inflation
28
Figure 9
The price level & real GDP output in U.S., 1972–2007
29
Applying Model to a Growing Economy
• Every year
– Aggregate demand – grows
• Shift right
• Growing population
– More demand: consumer & investment goods
• Increased government purchases
– Aggregate supply – shift right
• More workers
• Investment & technology
– Improve productivity
30
Figure 10
Aggregate supply & demand analysis: growing economy
D1
S0
Price Level (P)
(2000=100)
D0
S1
B
116.5
A
113
D1
S0
D0
S1
11,000
11,330
Real GDP (Y) in Billions of 2000 Dollars
31
Applying Model to a Growing Economy
• Demand-side fluctuations
– For Aggregate supply – grows, and
• If: Aggregate demand – grows faster
– Faster growth
– More inflation
– Economic boom
• If: Aggregate demand – grows slower
– Slower growth
– Less inflation
– Economic recession
32
Figure 11
The effects of faster growth of aggregate demand
D2
S0
S1
C
120
Price Level (P)
(2000=100)
D0
D2
A
113
S0
D0
S1
11,000
11,500
Real GDP (Y) in Billions of 2000 Dollars
33
Figure 12
The effects of slower growth of aggregate demand
S0
D3
S1
Price Level (P)
(2000=100)
D0
A
115
113
S0
E
D3
D0
S1
11,000 11,165
Real GDP (Y) in Billions of 2000 Dollars
34
Applying Model to a Growing Economy
• Supply-side fluctuations
– For Aggregate demand – grows, and
• If: Aggregate supply – shifts inward
– Real output – decline slightly
– Prices – rapid increase
– Stagflation
• If: Aggregate supply – grows faster
– Favorable supply shock
– Faster economic growth
– Lower inflation
35
Figure 13
Stagflation from an adverse supply shock
S1
D1
Price Level
(2000=100)
39.0
S0
B
D0
E
31.8
D1
D0
S1
S0
4,311
4,342
Real GDP (Y) in Billions of 2000 Dollars
36
Figure 14
The effects of a favorable supply shock
Normal growth
of aggregate supply
D1
S0
S1
Price Level (P)
D0
C
Effect of favorable
supply shock
B
A
D1
S0
S1
D0
Real GDP (Y)
37
Big Picture
• Chapter 8: composition of AD and the
volatility of investment
• Chapter 9: changes in investment have
multiplier effects on AD (given price)
• This chapter: show how shifts in AD
curve cause fluctuations in both GDP and
price
38
A Role For Stabilization Policy
• Economy’s self-correcting mechanism
– Works slowly
• Government stabilization policy
– Improve workings of free market
Summary
•
•
•
•
•
•
AS curve: upward slope
Shifts of AS curve
Equilibrium of AS-AD
Self-Correcting Mechanism of
Economy
The process might be slow
Need government stabilization policy