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PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned,

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Presentation on theme: "PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned,"— Presentation transcript:

1 PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 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. 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

2 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 2 © 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.

3 Figure 1 An Aggregate Supply Curve 3 Real GDP Price Level S S © 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.

4 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 4 © 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.

5 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 5 © 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.

6 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 6 © 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.

7 Figure 2 A Shift of the Aggregate Supply Curve 7 0 Real GDP (Y) Price Level (P) 6,000 5,500 S 0 (lower wages) S0S0 S 1 (higher wages) S1S1 100 A B © 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.

8 The Aggregate Supply Curve Improvement in technology and productivity –Decrease business costs –Aggregate supply curve shifts outward/right 8 © 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 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 9 © 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.

10 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 10 © 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.

11 Figure 3 Equilibrium of Real GDP and the Price Level 11 5,200 5, ,0006,400 Real GDP (Y) 6, Price Level (P) D D S S E © 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.

12 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 12 © 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.

13 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 13 © 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.

14 Table 1 Determination of the Equilibrium Price Level 14 © 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.

15 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 15 © 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.

16 Figure 4 Inflation and the multiplier ,0006,400 Real GDP (Y) 6, Price Level (P) D0D0 D0D0 S S D1D1 D1D1 A $800 billion E1E1 E0E0 © 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.

17 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 17 © 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 (a) Recessionary and Inflationary Gaps Revisited 18 Real GDP Real Expenditure 45° C+I 0 +G+(X-IM) 6,000 7,000 Potential GDP B E Recessionary gap 0 Real GDP Price Level Recessionary gap 6,000 7,000 Potential GDP B S S D0D0 D0D0 E © 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 (b) Recessionary and inflationary gaps revisited 19 Real GDP Real Expenditure 45° C+I 1 +G+(X-IM) 7,000 Potential GDP E 0 Real GDP Price Level 7,000 Potential GDP S S D1D1 D1D1 E © 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 Figure 5 (c) Recessionary and inflationary gaps revisited 20 Real GDP Real Expenditure 45° C+I 2 +G+(X-IM) 8,000 7,000 Potential GDP B E Inflationary gap 0 Real GDP Price Level Inflationary gap 8,000 7,000 Potential GDP B S S D2D2 D2D2 E © 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.

21 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 21 © 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 Figure 6 The Elimination of a Recessionary Gap 22 Real GDP (Y) Price Level (P) Recessionary gap 5,000 6,000 Potential GDP B S0S0 S0S0 D D S1S1 S1S1 F E 100 © 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.

23 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 23 © 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.

24 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 24 © 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.

25 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 25 © 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.

26 Adjusting to a Recessionary Gap Core inflation in the U.S. –Fell steadily, 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 26 © 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.

27 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 27 © 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.

28 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 28 © 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.

29 Figure 7 The Elimination of an Inflationary Gap 29 Real GDP (Y) Price Level (P) Inflationary gap Potential GDP B S0S0 S0S0 D D S1S1 S1S1 F E © 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.

30 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 30 © 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.

31 Adjusting to an Inflationary Gap Stagflation in the U.S. –Long economic expansion of the 1980s Unemployment rate: 5% Inflationary gap – , inflation: from 4.4% to 6.1% – , real GDP growth: from 3.5% to -0.5% –Inflationary gap - virtually disappeared by mid © 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.

32 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 32 © 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.

33 Figure 8 Stagflation from an Adverse Shift in Aggregate Supply 33 S0S0 S0S0 D D S1S1 S1S1 A Real GDP Price Level (2005=100) 4,917 4, E © 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.

34 Applying the Model Applying the model to a growing economy Simple model –Aggregate demand –Aggregate supply –Equilibrium price level –Equilibrium level of real GDP 34 © 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.

35 Applying the Model U.S. : price level and real GDP, –Higher price level –Higher GDP –Growth and Inflation –Both aggregate demand and aggregate supply normally shift to the right each year 35 © 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.

36 Figure 9 The Price Level and Real GDP Output in the United States, 1972– © 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.

37 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 37 © 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.

38 Figure 10 Aggregate Supply and Demand Analysis of a Growing Economy 38 S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2005 Dollars Price Level (P) (2005=100) 12,620 13, A D1D1 D1D1 S1S1 S1S1 B © 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.

39 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 39 © 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.

40 Figure 11 The Effects of Faster Growth of Aggregate Demand 40 S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2005Dollars Price Level (P) (2005=100) 12,620 13, A D2D2 D2D2 S1S1 S1S1 C © 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.

41 Figure 12 The Effects of Slower Growth of Aggregate Demand 41 S0S0 S0S0 D0D0 D0D0 Real GDP (Y) in Billions of 2005 Dollars Price Level (P) (2005=100) 12,620 12, A D3D3 D3D3 S1S1 S1S1 E © 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.

42 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 42 © 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.

43 Figure 13 Stagflation from an Adverse Supply Shock 43 S0S0 S0S0 D0D0 D0D0 S1S1 S1S1 Real GDP (Y) in Billions of 2005 Dollars Price Level (2005=100) 4,917 4, E D1D1 D1D1 B © 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.

44 Figure 14 The Effects of a Favorable Supply Shock 44 Real GDP (Y) Price Level (P) S0S0 S0S0 D0D0 D0D0 A D1D1 D1D1 S1S1 S1S1 B C Normal growth of aggregate supply Effect of favorable supply shock © 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.

45 A Role For Stabilization Policy Economy’s self-correcting mechanism –Works slowly Government stabilization policy –Improve the workings of free market 45 © 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.


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