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CHAPTER 16 • Analysis of AS curve • Phillips curve • Supply shocks • Laffer curves SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY Short Run Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Long Run Period in which nominal wages are fully responsive to previous changes in the price level AGGREGATE SUPPLY • Usually assume it is stable • IN REALITY: – IF PRICE AND OUTPUT INCREASES--• WORKERS NEED MORE $ TO BUY THINGS • NOMINAL WAGES INCREASE TO RESTORE PURCHASING POWER • IN THE LONG RUN---LR AS changes because of changes in nominal wages 3 ASSUMPTIONS OF SR AS • 1-PRICE LEVEL SET • 2-NOMINAL WAGES SET • 3-PRICE IS FLEXIBLE UP AND DOWN SHORT-RUN AGGREGATE SUPPLY A higher price level increases profits and output moving the economy from a1 to a2. AS1 Price Level P2 P1 o a2 a1 Qf Q2 Real domestic output SHORT-RUN AGGREGATE SUPPLY A lower price level decreases profits and output moving the economy from a1 to a3 . AS1 Price Level P2 a2 P1 P3 o a1 a3 Q3 Qf Q2 Real domestic output LONG-RUN AGGREGATE SUPPLY A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left . ASLR AS2 Price Level P2 P1 o b1 AS1 a2 a1 Qf Real domestic output LONG-RUN AGGREGATE SUPPLY A lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right . ASLR AS2 b1 Price Level P2 AS1 a2 AS3 a1 P1 P3 o a3 c1 Qf Real domestic output DIFFERENCES BETWEEN SR & LR • SR AS • NOMINAL WAGES • STAY SAME AS PRICE CHANGES COLA CLAUSES & RAISES TAKE TIME • LRAS • VERTICAL LINE • NOMINAL WAGES EVENTUALLY CHANGE BY THE SAME AMOUNT AS PRICE LEVEL EQUILIBRIUM IN THE EXTENDED AD-AS MODEL ASLR Price Level AS1 a P1 AD1 o Qf Real domestic output DEMAND-PULL INFLATION ASLR AS2 Price Level AS1 c P3 b P2 a P1 AD2 AD1 o Q f Q1 Real domestic output COST-PUSH INFLATION Occurs when short-run AS shifts left ASLR AS2 Price Level AS1 b P2 a P1 AD1 o Q2 Q f Real domestic output COST-PUSH INFLATION If government allows a recession to occur ASLR AS2 Price Level AS1 b P2 a P1 AD1 o Q2 Q f Real domestic output COST-PUSH INFLATION Government response with increased AD ASLR AS2 Price Level AS1 c P3 b P2 a P1 Even higher price levels AD2 AD1 o Q2 Q f Real domestic output Effect of Changes in AD on Real Output and Price Level Price Level ASsr PL3 PL2 AD3 PL1 AD2 AD1 o Y1 Y2 Y3 Real domestic output Inflation-Unemployment Relationship • Normally, there is a short-run trade-off between the rate of inflation and the the rate of unemployment caused by changes in AD. • AS shocks cause • higher rates of inflation • higher rates of unemployment. • There is no significant trade-off over long periods of time. The Phillips Curve Concept Annual rate of inflation 7 As inflation declines... 6 5 4 Unemployment increases 3 2 1 0 PC 1 2 3 4 5 6 7 Unemployment rate (percent) The Phillips Curve Trade-Off AS AD3 AD2 AD1 C B A REAL OUTPUT INFLATION RATE PRICE LEVEL √ Increases in AD causes movements along the Phillips Curve. √ As AD changes, the tradeoff between rate of inflation and rate of unemployment moves to a new position on PC. PC Phillips curve C B A UNEMPLOYMENT RATE The Phillips Curve Trade-Off Short Run Summary √ In the short run, changes in aggregate demand are movements along the short-run aggregate supply curve. √ If Aggregate Demand moves upward, price level rises and Real GDP rises and is reflected as a new point on the short-run Phillips curve showing higher rate of inflation and higher unemployment. √ If AD moves down, price level falls and Real GDP falls and is reflected as a new point on the shortrun Phillips curve showing lower rate of inflation and lower unemployment. Phillips Curve in the 1960s Phillips Curve Shifting in the 70s and 80s Phillips “Curl” Unemployment got worse but so did inflation. Aggregate Supply and Shifting Views Adverse supply shocks can cause periods of rising unemployment and rising inflation. Rapid and significant increases in resource prices push Aggregate Supply to the left. Price Level AS3sr AS2sr ASsr PL3 PL2 PL1 o AD1 Y3 Y2 Y1 Real domestic output HISTORICAL EVIDENCE • OPEC OIL INCREASES IN THE 70’S + • AGRIC. PROBLEMS + • DEPRECIATION OF THE $ === RISE IN WAGES • BUT—DECLINING PRODUCTIVITY AS JAPAN BECOMES AN ECON POWER & THE US ISN’T • ==== STAGFLATION 1980’S & 1990’S • HIGH UNEMPLOYMENT---LOWER WAGE INCREASES (OR NONE) + • FOREIGN COMPETITION ==== HOLDS DOWN PRICES & WAGES • DEREGULATION (AIR/PHONE ETC) + DECLINE OF OPEC === SR AS SHIFTED BACK AND LRAS ADJUSTS Changes in AS move the Phillips Curve AS2sr ASsr PL3 PL2 PL1 o AD1 Y3 Y2 Y1 Real domestic output Annual rate of inflation AS3sr 7 6 5 4 3 PC3 2 PC2 1 0 PC1 1 2 3 4 5 6 7 Unemployment rate (percent) Phillips Curve Long Run AD changes move along the Philllips Curve 15% SRPC3 LRPC 12% b3 SRPC2 9% a3 b2 SRPC1 a2 6% PC3 b1 a1 3% Inflat. Gap 0 Recess. Gap AS changes move the Phillips Curve PC2 PC1 2% 4% 6% 8% 10% Unemployment Rate Phillips Curve Long Run 1. Increases in AD beyond full employment temporarily boost profits, output and employment. (a1 to b1). 2. Nominal wages eventually catch up to sustain real wages; profit fall, canceling the short-run effect with employment returning to its full employment level.(b1 to a2), but at higher inflation. 3. The cycle starts again as AD grows, profits grow and employment rises (a2 to b2) 4. Again, in time, nominal wages catch up and employment returns to its natural rate. The reward is a higher inflation rate. The Phillips Curve —Long Run Summary √ There is not a stable relationship between unemployment and inflation as shown. √ The long-run Phillips curve is the vertical line through a1, a2, and a3 at the natural rate of unemployment. √ Any rate of inflation is consistent with the 5% natural rate of unemployment. √ After all nominal wage adjustments to increases or decreases in inflation have occurred, the economy ends up back at fullemployment natural rate position. THE LAFFER CURVE Tax rate (percent) 100 l 0 Tax revenue (dollars) THE LAFFER CURVE 100 Tax rate (percent) n m l 0 Tax revenue (dollars) THE LAFFER CURVE Tax rate (percent) 100 n m m Maximum Tax Revenue l 0 Tax revenue (dollars) SUPPLY SIDE ECONOMICS • AS is what determines inflation, growth and • unemployment High tax rates----hurt productivity – Also: discourage econ activity – Tax evasion • Low tax rates (for businesses) encourage investment – Encourage work, savings – Rewards for consumers who save decreases with higher marginal tax rates – Encourage people to enter labor force reducing unemployment – Increasing productivity – AS expands and keeps inflation low CRITICISMS OF THE LAFFER CURVE • Economic incentives don’t have as large an impact • If decrease taxes when close to peak---get inflation thru increased AD • 1980’s—Reaganomics—proves Laffer curve correct with some exceptions