CHAPTER 16 Analysis of AS curve Analysis of AS curve Phillips curve Phillips curve Supply shocks Supply shocks Laffer curves Laffer curves

SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Short Run - Period in which nominal wages are fully responsive to previous changes in the price level Long Run -

AGGREGATE SUPPLY Usually assume it is stable Usually assume it is stable IN REALITY: IN REALITY: –IF PRICE AND OUTPUT INCREASES--- WORKERS NEED MORE $ TO BUY THINGS WORKERS NEED MORE $ TO BUY THINGS NOMINAL WAGES INCREASE TO RESTORE PURCHASING POWER NOMINAL WAGES INCREASE TO RESTORE PURCHASING POWER IN THE LONG RUN---LR AS changes because of changes in nominal wages IN THE LONG RUN---LR AS changes because of changes in nominal wages

3 ASSUMPTIONS OF SR AS 1-PRICE LEVEL SET 1-PRICE LEVEL SET 2-NOMINAL WAGES SET 2-NOMINAL WAGES SET 3-PRICE IS FLEXIBLE UP AND DOWN 3-PRICE IS FLEXIBLE UP AND DOWN

o AS 1 P1P1 P2P2 QfQf Q2Q2 a1a1 a2a2 A higher price level increases profits and output moving the economy from a 1 to a 2. Price Level Real domestic output SHORT-RUN AGGREGATE SUPPLY

o AS 1 P1P1 P2P2 QfQf a1a1 a2a2 A lower price level decreases profits and output moving the economy from a 1 to a 3. Price Level Real domestic output SHORT-RUN AGGREGATE SUPPLY P3P3 a3a3 Q2Q2 Q3Q3

o AS 1 P1P1 P2P2 QfQf a2a2 a1a1 AS 2 b1b1 AS LR Price Level 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.

o P3P3 AS 1 P1P1 P2P2 QfQf a2a2 a3a3 a1a1 AS 2 b1b1 AS 3 c1c1 AS LR Price Level 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.

DIFFERENCES BETWEEN SR & LR SR AS SR AS NOMINAL WAGES STAY SAME AS PRICE CHANGES NOMINAL WAGES STAY SAME AS PRICE CHANGES COLA CLAUSES & RAISES TAKE TIME COLA CLAUSES & RAISES TAKE TIME LRAS LRAS VERTICAL LINE VERTICAL LINE NOMINAL WAGES EVENTUALLY CHANGE BY THE SAME AMOUNT AS PRICE LEVEL NOMINAL WAGES EVENTUALLY CHANGE BY THE SAME AMOUNT AS PRICE LEVEL

EQUILIBRIUM IN THE EXTENDED AD-AS MODEL o P1P1 AS 1 AS LR AD 1 a QfQf Price Level Real domestic output

DEMAND-PULL INFLATION o P1P1 AS 1 AS LR AD 1 a QfQf Price Level Real domestic output b P2P2 P3P3 AD 2 AS 2 c Q1Q1

Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a QfQf Price Level Real domestic output b P2P2 AS 2 Occurs when short-run AS shifts left

COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a QfQf Price Level Real domestic output b P2P2 AS 2 If government allows a recession to occur Q2Q2

Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a QfQf Price Level Real domestic output b P2P2 P3P3 AD 2 AS 2 Government response with increased AD c Even higher price levels

Effect of Changes in AD on Real Output and Price Level o PL 1 Y1Y1Y1Y1 AD 1 AS sr Price Level Real domestic output AD 2 PL 2 Y2Y2Y2Y2 AD 3 PL 3 Y3Y3Y3Y3

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.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 causeAS shocks cause higher rates of inflationhigher rates of inflation higher rates of unemployment.higher rates of unemployment. There is no significant trade-off over long periods of time.There is no significant trade-off over long periods of time.

Annual rate of inflation Unemployment rate (percent) As inflation declines... The Phillips Curve Concept Unemploymentincreases PC

The Phillips Curve Trade-Off UNEMPLOYMENT RATE INFLATION RATE REAL OUTPUT 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. B C AD 1 AD 2 A AD 3 Phillips curve C B A AS PC

√ 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 short- run Phillips curve showing lower rate of inflation and lower unemployment. The Phillips Curve Trade-Off Short Run Summary

Phillips Curve in the 1960s

Phillips Curve Shifting in the 70s and 80s

Phillips “Curl” Unemployment got worse but so didinflation.

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. Aggregate Supply and Shifting Views o PL 1 Y1Y1Y1Y1 AD 1 AS sr Price Level Real domestic output PL 2 Y2Y2Y2Y2 PL 3 Y3Y3Y3Y3 AS 2 sr AS 3 sr

HISTORICAL EVIDENCE OPEC OIL INCREASES IN THE 70’S + OPEC OIL INCREASES IN THE 70’S + AGRIC. PROBLEMS + AGRIC. PROBLEMS + DEPRECIATION OF THE $ === RISE IN WAGES DEPRECIATION OF THE $ === RISE IN WAGES BUT—DECLINING PRODUCTIVITY AS JAPAN BECOMES AN ECON POWER & THE US ISN’T BUT—DECLINING PRODUCTIVITY AS JAPAN BECOMES AN ECON POWER & THE US ISN’T ==== STAGFLATION ==== STAGFLATION

1980’S & 1990’S HIGH UNEMPLOYMENT---LOWER WAGE INCREASES (OR NONE) + HIGH UNEMPLOYMENT---LOWER WAGE INCREASES (OR NONE) + FOREIGN COMPETITION ==== HOLDS DOWN PRICES & WAGES FOREIGN COMPETITION ==== HOLDS DOWN PRICES & WAGES DEREGULATION (AIR/PHONE ETC) + DECLINE OF OPEC === SR AS SHIFTED BACK AND LRAS ADJUSTS DEREGULATION (AIR/PHONE ETC) + DECLINE OF OPEC === SR AS SHIFTED BACK AND LRAS ADJUSTS

Changes in AS move the Phillips Curve o PL 1 Y1Y1Y1Y1 AD 1 AS sr Price Level Real domestic output PL 2 Y2Y2Y2Y2 PL 3 Y3Y3Y3Y3 AS 2 sr AS 3 sr Annual rate of inflation Unemployment rate (percent) PC 1 PC 2 PC 3

15% SRPC3SRPC3SRPC3SRPC3 SRPC1SRPC1SRPC1SRPC1 SRPC2SRPC2SRPC2SRPC2 a1a1a1a1 a2a2a2a2 a3a3a3a3 b1b1b1b1 b2b2b2b2 b3b3b3b3 PC1 PC 2 PC 3 LRPC Inflat.GapRecess.Gap Inflation Rate Unemployment Rate 12% 9% 6% 3% 0 2%4%6%8%10% Phillips Curve Long Run AD changes move along the Philllips Curve AS changes move the Phillips Curve

1. Increases in AD beyond full employment temporarily boost profits, output and employment. (a 1 to b 1 ). 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.(b 1 to a 2 ), but at higher inflation. 3. The cycle starts again as AD grows, profits grow and employment rises (a 2 to b 2 ) 4. Again, in time, nominal wages catch up and employment returns to its natural rate. The reward is a higher inflation rate. Phillips Curve Long Run

√ There is not a stable relationship between unemployment and inflation as shown. √ There is not a stable relationship between unemployment and inflation as shown. √ The long-run Phillips curve is the vertical line through a 1, a 2, and a 3 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 full- employment natural rate position. The Phillips Curve —Long Run Summary

0 100 l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

0 100 m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

0 100 m m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent) Maximum Tax Revenue

SUPPLY SIDE ECONOMICS AS is what determines inflation, growth and unemployment AS is what determines inflation, growth and unemployment High tax rates----hurt productivity High tax rates----hurt productivity –Also: discourage econ activity –Tax evasion Low tax rates (for businesses) encourage investment 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 Economic incentives don’t have as large an impact If decrease taxes when close to peak---- get inflation thru increased AD If decrease taxes when close to peak---- get inflation thru increased AD 1980’s—Reaganomics—proves Laffer curve correct with some exceptions 1980’s—Reaganomics—proves Laffer curve correct with some exceptions