Download Chapter 15 Long Run Macroeconomic Adjustments

Long-Run Macroeconomic
Adjustments
SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
1
In this chapter you will learn
14.1 To apply the long-run AD-AS
model to explain inflation,
recessions, and unemployment
14.2 About the inflationunemployment relationship
14.3 The long-run Phillips Curve
14.4 About the effects of taxation on
aggregate supply
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
2
Chapter 14 Topics
14.1 Applying the Long-Run AD-AS
Model
14.2 The Inflation-Unemployment
Relationship
14.3 The Long-Run Phillips Curve
14.4 Taxation & Aggregate Supply
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
3
Applying the Long-Run ADAS Model
 Demand-pull
inflation occurs when
an increase in aggregate demand
pulls up the price level
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
4
Demand-Pull Inflation
Figure 14-1
Price Level
AD1
AS1
The starting
point is full
employment
GDP (GDPf )
P1
o
GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
5
Demand-Pull Inflation
Figure 14-1
Price Level
AD1
AS1
Something
causes AD to
increase…
what are some
possibilities?
P1
o
GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
6
Demand-Pull Inflation
Figure 14-1
Price Level
AD1
AD2
AS1
P2
Higher
demand
leads to a
higher price
level, and
higher output
P1
o
GDPf GDP2
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
7
Demand-Pull Inflation
Figure 14-1
Price Level
AD1
AD2
AS1
P2
A higher price
level (P2 )
EVENTUALLY
leads to higher
nominal wages
which causes....
P1
o
GDPf GDP2
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
8
Demand-Pull Inflation
Figure 14-1
Price Level
AD1
AD2
AS2
AS1
P3
P2
A left shift of
the short run
AS curve
P1
o
GDPf GDP2
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
9
Demand-Pull Inflation
 in
the short run, demand-pull
inflation drives up prices and output
 in the long run, output is restored to
GDPf and only the price level is
higher
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
10
Cost-Push Inflation
 Cost-push
inflation arises from
factors that increase the cost of
production at each price level
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
11
Cost-Push Inflation
Figure 14-2
ASLR
Price Level
AD1
AS1
Something
drives up
production
costs…such
as?
P1
o
GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
12
Cost-Push Inflation
Figure 14-2
ASLR
AS2
Price Level
AD1
AS1
AS shifts to
the left,
leading to
higher
prices and
lower output
P2
P1
o
GDP2 GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
13
Cost-Push Inflation
Figure 14-2
ASLR
AS2
Price Level
AD1
AS1
Now what?
P2
P1
Left alone, the
economy will
eventually
make its way
back to GDPf
o
GDP2 GDPf
HOW?
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
14
Cost-Push Inflation
Figure 14-2
ASLR
AS2
Price Level
AD1
AS1
Layoffs, high
unemployment
will eventually
lead to lower
factor prices
P2
P1
o
GDP2 GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
15
Cost-Push Inflation
Figure 14-2
ASLR
AS2
Price Level
AD1
AS1
What other
options are
there?
P2
P1
o
GDP2 GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
16
Cost-Push Inflation
AD2
Figure 14-2
ASLR
AS2
AD1
AS1
Price Level
P3
P2
P1
Expansionary
fiscal or
monetary
policy
o
GDP2 GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
17
Cost-Push Inflation
AD2
Figure 14-2
ASLR
AS2
AD1
AS1
Price Level
P3
P2
P1
But this leads
to higher
inflation
o
GDP2 GDPf
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
18
Cost-Push Inflation
 if
government attempts to maintain
full employment, an inflationary
spiral may occur
 otherwise, there will be a recession,
with high unemployment and a loss
of output
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
19
Recession & the Long-Run
AD-AS Model
 how
long would it take in the real
world for price & wage adjustments
to occur, to regain full employment?
 there is disagreement among
economists about how long
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
20
Chapter 14 Topics
14.1 Applying the Long-Run AD-AS
Model
14.2 The Inflation-Unemployment
Relationship
14.3 The Long-Run Phillips Curve
14.4 Taxation & Aggregate Supply
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
21
The Inflation-Unemployment
Relationship
Under normal circumstances, there is a
short-run tradeoff between inflation &
unemployment
 Aggregate supply shocks can cause both
higher inflation & higher unemployment
 There is no significant tradeoff between
inflation & unemployment over long
periods of time

© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
22
The Phillips Curve
 Assuming
a constant AS, high rates
of inflation are accompanied by low
rates of unemployment, & vice-versa
illustrated…
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
23
The Phillips Curve
Figure 14-4
Price Level
AS
P0
AD0
o
GDP0
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
24
The Phillips Curve
Figure 14-4
Price Level
AS
P1
P0
AD0
o
AD1
GDP0 GDP1
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
25
The Phillips Curve
Figure 14-4
Price Level
AS
P2
P1
AD2
P0
AD0
o
AD1
GDP0 GDP1 GDP2
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
26
The Phillips Curve
Figure 14-4
AS
Price Level
P3
AD3
P2
P1
AD2
P0
AD0
o
AD1
GDP0 GDP1 GDP2GDP3
Real domestic product
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
27
Figure 14-5
Phillips Curve
Concept & Canadian Data
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
28
The Phillips Curve
 Modern
economists reject the idea
of a stable, predictable long-run
Phillips Curve
 They agree there is a short-run
tradeoff between inflation &
unemployment
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
29
Aggregate Supply Shocks &
the Phillips Curve
 In
the late 1970s and early 1980s,
the economy experienced
stagflation
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
30
Adverse Aggregate Supply
Shocks
 OPEC
and Energy Prices
 Other shocks:
– agricultural shortfalls
– dollar depreciation
– wage increases after wage-price
controls lifted
– declining productivity
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
32
Figure 14-6
A Shifting Phillips Curve?
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
33
Stagflation’s Demise
 by
the late 80’s, it appeared the
Phillips curve had shifted back
– recession of 81-83
– increased foreign competition
– deregulation of airlines and trucking
– decline in OPEC’s power
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
34
Chapter 14 Topics
14.1 Applying the Long-Run AD-AS
Model
14.2 The Inflation-Unemployment
Relationship
14.3 The Long-Run Phillips Curve
14.4 Taxation & Aggregate Supply
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
35
The Long-Run Phillips
Curve
 There
is no apparent long-run
tradeoff between inflation &
unemployment
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
36
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
economy is at a1
with unemployment
at 5%, and inflation
at 3%; suppose
wages are set on the
assumption of 3%
inflation
12
PC1
9
6
a1
3
0
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
37
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
suppose AD
increases & inflation
increases to 6%;
economy moves to
b1
12
PC1
9
6
b1
a1
3
0
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
38
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
but b1 is not a stable
equilibrium; workers
will demand higher
wages; economy
moves to a2
12
PC1
9
6
a2
b1
a1
3
0
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
39
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
12
Phillips Curve shifts
upward from PC1 to
PC2
PC2
PC1
9
6
a2
b1
a1
3
0
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
40
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
scenario repeats if
AD increases again
PC3
12
PC2
PC1
9
b2
6
b1
a3
a2
a1
3
0
so any rate of
inflation is possible
with the 5% natural
rate of
unemployment
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
41
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
PC3
12
PC2
PC1
9
b2
6
b1
a3
a2
a1
3
0
the long-run Phillips
Curve is vertical at
the 5% natural rate
of unemployment
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
42
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
what about
disinflation?
PC3
12
suppose the
economy is at a3 &
AD declines
a3
9
c3
6
3
0
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
43
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
firms & workers
eventually adjust to
lower 6% inflation
PC3
12
PC2
9
a3
6
a2
c3
3
0
3
4
5
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
44
The Long-Run Phillips Curve
Annual rate of inflation
(percent)
Figure 14-7
PCLR
15
if AD falls further, the
scenario will
continue
PC3
12
PC2
PC1
9
a3
6
a2
a1
3
0
c3
3
4
5
c2
6
Unemployment rate (per cent)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
45
Chapter 14 Topics
14.1 Applying the Long-Run AD-AS
Model
14.2 The Inflation-Unemployment
Relationship
14.3 The Long-Run Phillips Curve
14.4 Taxation & Aggregate Supply
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
46
Taxation & Aggregate
Supply
 Government
policies can impede or
promote rightward shifts of AS
 Effects of taxation on the supply
curve are key concerns of supply
side economics
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
47
Taxes & Incentives to Work
 Reductions
in marginal tax rates on
earned incomes induce more work
 Lower marginal tax rates make
leisure relatively more expensive
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
48
Incentives to Save & Invest
 Lower
marginal tax rates increase
the rewards for saving & investing
 Saving is a prerequisite for
investment
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
49
The Laffer Curve
 It
is possible that reductions in
marginal tax rates will increase AS
but leave tax revenues unchanged
illustrated…
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
50
Laffer Curve
Figure 14-8
100
Tax rate (percent)
Shows impact of tax rates
upon tax collections
0
Tax revenue (dollars)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
51
Laffer Curve
Figure 14-8
100
Tax rate (percent)
increase tax
rates and tax
revenues
increase
l
0
Tax revenue (dollars)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
52
Laffer Curve
Figure 14-8
Tax rate (percent)
100
tax revenues
increase at a
decreasing
rate as rates
m rise further
m
l
0
Tax revenue (dollars)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
53
Laffer Curve
Figure 14-8
100
Tax rate (percent)
n
m
m
l
at some
point, rates
are so high
that
economic
activity
decreases,
and cheating
increases
0
Tax revenue (dollars)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
54
Laffer Curve
Figure 14-8
100
Tax rate (percent)
n
m
m
l
0
Tax revenue (dollars)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
55
Criticisms of the Laffer Curve
 Taxes,
Incentives and Time
– substitution effect as well as income
effect
 Inflation
– demand side effects may be
greater/quicker
 Position
on Curve
– where are we?
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
56
Chapter 14 Topics
14.1 Applying the Long-Run AD-AS
Model
14.2 The Inflation-Unemployment
Relationship
14.3 The Long-Run Phillips Curve
14.4 Taxation & Aggregate Supply
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 14
57