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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
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
The Aggregate Supply Curve
• Aggregate supply curve
– Shows, for each possible price level
• The quantity of goods and services
• That all the nation’s businesses are willing to
produce
• During a specified period of time
• All other determinants constant
– Slopes upward
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
Figure 1
An Aggregate Supply Curve
Price Level
S
S
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
The Aggregate Supply Curve
• Unit profit
= Price – Unit cost
• Aggregate supply curve slopes upward
– Firms can purchase inputs
• At prices that are fixed for some period of
time
– Higher selling prices for output
• Makes production more attractive
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
The Aggregate Supply Curve
• Aggregate supply curve
– Shifts outward [to the right]
• More output produced at any given price level
– Shifts inward [to the left]
• Less output produced at any given price level
– Determinants:
• Prices of inputs
• Technology and productivity
• Available supplies of labor and capital
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
The Aggregate Supply Curve
• Increase in nominal wage rate
– Higher real production costs
– Aggregate supply curve shifts inward/left
• Increase in prices of other inputs
– Higher real production costs
– Aggregate supply curve shifts inward/left
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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)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
The Aggregate Supply Curve
• Improvement in technology and
productivity
– Decrease business costs
– Aggregate supply curve shifts
outward/right
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
The Aggregate Supply Curve
• Greater available supply of labor and
capital
– When the labor force grows or improves in
quality
– Or/and the capital stock increases
(investment)
– Aggregate supply curve shifts
outward/right
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
Equilibrium
• Equilibrium of aggregate demand and
supply
• Equilibrium GDP
– Aggregate demand curve intersects
aggregate supply curve
– Equilibrium price level
– Aggregate quantity demanded equals
aggregate quantity supplied
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
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)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
Equilibrium
• For price level > Equilibrium price level
– Aggregate quantity supplied exceeds
aggregate quantity demanded
– Inventories increase
• Prices are forced down
– Price level falls
– Production falls
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12
Equilibrium
• For price level < Equilibrium price level
– Aggregate quantity demanded exceeds
aggregate quantity supplied
– Shortage of goods
– Inventories decrease
• Prices increase
– Price level rises
– Production rises
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
Table 1
Determination of the Equilibrium Price Level
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14
Inflation and the Multiplier
• Actual numerical value of multiplier
– Smaller – oversimplified multiplier formula
• Aggregate supply curve slopes upward
– Any increase in aggregate demand
• Will push up the price level
• Erodes purchasing power of consumer
wealth
• Reduces net exports
– Inflation reduces the value of multiplier
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
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
6,800
Real GDP (Y)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
Recessionary and Inflationary Gaps
• Recessionary gap
– Amount by which equilibrium real GDP
exceeds the full-employment level of GDP
– Aggregate demand – weak
• Inflationary gap
– Amount by which the equilibrium level of
real GDP falls short of potential GDP
– Excess aggregate demand
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
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
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18
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
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
19
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
0
Real GDP
S
D2
7,000 8,000
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
20
Adjusting to a Recessionary Gap
• Deflation or Unemployment?
• Recessionary gap
– Equilibrium below potential GDP
• Cyclical unemployment
– Wages may fall
• Aggregate supply – shift outward/right
– Increase GDP to Potential GDP
– Prices decline
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
21
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)
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
Adjusting to a Recessionary Gap
• Why nominal wages and prices won’t fall
(easily)
– Institutional factors
– Psychological resistance to wage
reduction
– Business cycles – less severe
– Firms – don’t want to lose best employees
• Economy gets stuck
– Recessionary gap - long period
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
23
Adjusting to a Recessionary Gap
• Self-correcting mechanism
– Workers need jobs - willing to cut wages
– Firms – willing to cut prices
• Economy’s self-correcting mechanism
– The way money wages react to either a
recessionary gap or an inflationary gap
– Wage changes shift the aggregate supply
curve
• Change equilibrium GDP and the equilibrium
price level
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24
Adjusting to a Recessionary Gap
• Deflation worries in the United States
– Deflation - twice in the past decade
• Driven by recessionary gaps
• “Core” inflation
– Inflation rate for all items other than food
and energy
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
25
Adjusting to a Recessionary Gap
• Core inflation in the U.S.
– Fell steadily, 2002 - 2003
• To barely over 1% per annum, end of 2003
– Rose to 2.5 – 3% as the economy
strengthened
– Fell steadily again during and after the
Great Recession
• Below 1% in April 2010 – and for the rest of
the year
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
26
Adjusting to an Inflationary Gap
• Inflationary gap
– Aggregate demand is exceptionally high
– Short-run equilibrium above full
employment
• Tight labor market
– Plentiful jobs
– Rising nominal wages
– Increase business costs
– Prices increase
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
27
Adjusting to an Inflationary Gap
• Inflation
– Higher prices cut into consumer
purchasing power and net exports
– Inflationary gap begins to close
– Output falls and prices continue to rise
– Long-run equilibrium
• Higher price level
• GDP equal to potential GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
28
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)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
Adjusting to an Inflationary Gap
• Self-correcting mechanism
– Tends to eliminate either unemployment o
inflation
– Works slowly and unevenly
– Not always reliable
• Stagflation
– Inflation that occurs while the economy is
growing slowly or having a recession
– Normal after excessive aggregate demand
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30
Adjusting to an Inflationary Gap
• Stagflation in the U.S.
– Long economic expansion of the 1980s
• Unemployment rate: 5%
• Inflationary gap
– 1988 - 1990, inflation: from 4.4% to 6.1%
– 1989 - 1991, real GDP growth: from 3.5%
to -0.5%
– Inflationary gap - virtually disappeared by
mid-1990
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31
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
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
32
Figure 8
Stagflation from an Adverse Shift in Aggregate Supply
Price Level
(2005=100)
S1
D
33.6
28.1
S0
A
E
D
S1
S0
4,880
4,917
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
33
Applying the Model
• Applying the model to a growing
economy
• Simple model
– Aggregate demand
– Aggregate supply
– Equilibrium price level
– Equilibrium level of real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
34
Applying the Model
• U.S. : price level and real GDP, 19722010
– Higher price level
– Higher GDP
– Growth and Inflation
– Both aggregate demand and aggregate
supply normally shift to the right each
year
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35
Figure 9
The Price Level and Real GDP Output in the United States,
1972–2010
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
36
Applying the Model
• Every year
– Aggregate demand shifts right
• Growing population
• More demand of consumer and investment
goods
• Increased government purchases
– Aggregate supply shifts right
• More workers
• Investment and technology
– Improve productivity
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
Figure 10
Aggregate Supply and Demand Analysis of a Growing
Economy
D1
S0
Price Level (P)
(2005=100)
D0
S1
B
103
A
100
D1
S0
D0
S1
12,620
13,000
Real GDP (Y) in Billions of 2005 Dollars
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38
Applying the Model
• Demand-side fluctuations
– For any given growth rate of aggregate
supply, and
• A faster growth rate of aggregate demand
– Faster growth
– More inflation
• A slower growth rate of aggregate demand
– Slower growth
– Less inflation
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39
Figure 11
The Effects of Faster Growth of Aggregate Demand
D2
S0
S1
C
106
Price Level (P)
(2005=100)
D0
D2
A
100
S0
D0
S1
12,620
13,250
Real GDP (Y) in Billions of 2005Dollars
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
40
Figure 12
The Effects of Slower Growth of Aggregate Demand
S0
D3
S1
Price Level (P)
(2005=100)
D0
A
100.5
100
S0
E
D3
D0
S1
12,620 12,800
Real GDP (Y) in Billions of 2005 Dollars
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41
Applying the Model
• Supply-side fluctuations
– For any given growth rate of aggregate
demand
• An inward shift of aggregate supply
– Real output – decline slightly
– Prices – rapid increase
• A faster growth rate of aggregate supply
– Favorable supply shock
– Faster economic growth
– Lower inflation
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42
Figure 13
Stagflation from an Adverse Supply Shock
S1
D1
Price Level
(2005=100)
33.6
S0
B
D0
E
28.1
D1
D0
S1
S0
4,880
4,917
Real GDP (Y) in Billions of 2005 Dollars
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
43
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)
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44
A Role For Stabilization Policy
• Economy’s self-correcting mechanism
– Works slowly
• Government stabilization policy
– Improve the workings of free market
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45