Bringing in the Supply Side: Unemployment and Inflation?

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 © 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.

The 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 © 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.

Figure 1 An Aggregate Supply Curve Price Level S 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.

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 © 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.

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 © 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.

Increase in nominal wage rate Higher real production costs Aggregate supply curve shifts inward/left Increase in prices of other inputs © 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.

Figure 2 A Shift of the Aggregate Supply Curve S1 (higher wages)
Price Level (P) S1 (higher wages) S1 S0 (lower wages) S0 B 100 5,500 6,000 A 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.

Improvement in technology and productivity Decrease business costs 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.

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.

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 © 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.

Figure 3 Equilibrium of Real GDP and the Price Level 80 90 100 110
Price Level (P) 120 130 S D E 5,200 5,600 6,000 6,400 Real GDP (Y) 6,800 © 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.

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 © 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.

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 © 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.

Table 1 Determination of the Equilibrium Price Level
© 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.

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 © 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.

Figure 4 Inflation and the multiplier D1 80 90 100 110 Price Level (P)
120 130 S D0 E1 E0 A $800 billion 6,000 6,400 Real GDP (Y) 6,800 © 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.

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 © 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.

Figure 5 (a) Recessionary and Inflationary Gaps Revisited
45° 7,000 Potential GDP Real Expenditure C+I0+G+(X-IM) E B 6,000 Recessionary gap Real GDP 7,000 Potential GDP Price Level S D0 E B Recessionary gap 6,000 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.

Figure 5 (b) Recessionary and inflationary gaps revisited
7,000 Potential GDP 45° Real Expenditure C+I1+G+(X-IM) E Real GDP 7,000 Potential GDP Price Level S D1 E 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.

Figure 5 (c) Recessionary and inflationary gaps revisited
45° 7,000 Potential GDP Real Expenditure Inflationary gap C+I2+G+(X-IM) B E 8,000 Real GDP 7,000 Potential GDP Price Level D2 E S Inflationary gap B 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.

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 © 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.

Figure 6 The Elimination of a Recessionary Gap 6,000 Potential GDP
Price Level (P) S0 D S1 E 100 B 5,000 Recessionary gap F 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.

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 © 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.

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 © 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.

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 © 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.

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 © 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.

Adjusting to an 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 © 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.

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 © 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.

Figure 7 The Elimination of an Inflationary Gap Potential GDP S1 F S0
Price Level (P) S1 D S0 F E B Inflationary gap 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.

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 © 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.

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-1990 © 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.

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 © 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.

Figure 8 Stagflation from an Adverse Shift in Aggregate Supply S1 A S0
Price Level (2005=100) S1 S0 A D 33.6 E 4,880 28.1 4,917 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.

Applying the Model Applying the model to a growing economy
Simple model Aggregate demand Aggregate supply Equilibrium price level Equilibrium level of 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.

Applying the Model U.S. : price level and real GDP, 1972-2010
Higher price level Higher GDP Growth and Inflation Both aggregate demand and aggregate supply normally shift to the right each year © 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.

Figure 9 The Price Level and Real GDP Output in the United States, 1972–2010 © 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.

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 © 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.

Real GDP (Y) in Billions of 2005 Dollars
Figure 10 Aggregate Supply and Demand Analysis of a Growing Economy D1 Price Level (P) (2005=100) S0 S1 D0 B 103 13,000 A 100 12,620 Real GDP (Y) in Billions of 2005 Dollars © 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.

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 © 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.

Real GDP (Y) in Billions of 2005Dollars
Figure 11 The Effects of Faster Growth of Aggregate Demand D2 S0 Price Level (P) (2005=100) S1 C 106 13,250 D0 A 100 12,620 Real GDP (Y) in Billions of 2005Dollars © 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.

Figure 12 The Effects of Slower Growth of Aggregate Demand Price Level (P) (2005=100) S0 S1 D3 D0 E A 100.5 100 12,800 12,620 Real GDP (Y) in Billions of 2005 Dollars © 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.

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 © 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.

Figure 13 Stagflation from an Adverse Supply Shock Price Level (2005=100) S1 D1 S0 B 33.6 D0 4,880 E 28.1 4,917 Real GDP (Y) in Billions of 2005 Dollars © 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.

Figure 14 The Effects of a Favorable Supply Shock Normal growth
of aggregate supply D1 Price Level (P) S0 D0 S1 C Effect of favorable supply shock B A 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.

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

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Bringing in the Supply Side: Unemployment and Inflation?

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