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26 Supply-Side Equilibrium: 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 Contents ● The Aggregate Supply Curve ● Equilibrium of Aggregate Demand and Supply ● Recessionary and Inflationary Gaps Revisited ● Adjusting to a Recessionary Gap: Deflation or Unemployment? Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Contents (continued) ● Adjusting to an Inflationary Gap: Inflation ● Stagflation from a Supply Shock ● Inflation and the Multiplier ● A Role for Stabilization Policy Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Aggregate Supply Curve ● The aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied, holding all other determinants of quantity supplied constant. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 26-1 An Aggregate Supply Curve FIGURE Price Level S S Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Aggregate Supply Curve ● Why the Aggregate Supply Curve Slopes Upward ♦ Firms normally can purchase labor and other inputs at prices that are fixed for some period of time. ♦ Higher prices, thus, mean higher profits and more incentive to produce. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Aggregate Supply Curve ● Shifts of the Aggregate Supply Curve ♦ Costs of production are constant along the AS curve. ♦ costs of production shifts in the AS curve ■The money wage rate ■Prices of other inputs ■Technology and productivity ■Available supplies of labor and capital Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 26-2 A Shift of the Aggregate Supply Curve FIGURE S1 (higher wages) S0 (lower wages) B Price Level 100 A S1 S0 5,500 6,000 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Aggregate Supply Curve ● Shifts of the Aggregate Supply Curve ♦ cost of production inward shift of AS curve ■Money wage rate ■Interest rate ■Materials prices Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Aggregate Supply Curve ● Shifts of the Aggregate Supply Curve ♦ costs of production outward shift of AS curve ■Improvements in technology ■Increases in productivity ■Increases in supplies of labor and capital Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Equilibrium of Aggregate Demand and Supply ● Price level adjustments AS-AD equilibrium ● Imbalance between AS and AD inventories price quantity of AS and AD Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 26-3 Equilibrium of Real GDP and the Price Level FIGURE S Price Level D 130 120 110 100 90 80 E S D 5,200 5,600 6,000 6,400 6,800 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 26-1 Determination of the Equilibrium Price Level TABLE Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Recessionary and Inflationary Gaps Revisited ● Short run: AS-AD equilibrium may or may not equal full employment GDP ♦ Recessionary gap: Equilibrium GDP < Potential GDP ♦ Inflationary gap: Equilibrium GDP > Potential GDP Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Recessionary and Inflationary Gaps Revisited ● Long-run: market forces make equilibrium GDP = potential GDP Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 26-5 The Elimination of a Recessionary Gap FIGURE Potential GDP S0 Price Level S1 D E 100 B F S0 Recessionary gap D S1 5,000 6,000 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Adjusting to a Recessionary Gap ● When unemployment exists, if money wages fall: ♦ The aggregate supply curve will shift outward ♦ Full employment will be attained eventually Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ● In the real economy, however, wage reductions are slow and uncertain, particularly in the post-World War II period. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ● There are several possible reasons why wages are so sticky in the downward direction: ♦ Institutional rigidities ♦ Psychological resistance ♦ Reduced severity of business cycles ♦ Competition for the best workers Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ● With sticky wages, cyclical unemployment may last a long time. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ● Does the Economy Have a Self-Correcting Mechanism? ♦ The economy will self-adjust eventually. ■ wages demand for labor ■ prices demand for goods and services ♦ But many people believe that government intervention should help to speed the process. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to a Recessionary Gap ● An Example from Recent History: Disinflation in Japan the 1990s ♦ Recovery from the 1990-1991 recession was weak and long delayed, but it did eventually come. ♦ Practical question: How long can we afford to wait? Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ● When GDP > full employment ♦ Price level rises ♦ Labor is in short supply ● Both forces money wages ♦ AS curve shifts inward ♦ Employment falls ♦ Eventually eliminates the inflationary gap Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 26-6 The Elimination of an Inflationary Gap FIGURE Potential GDP S1 D Price Level S0 F E B S1 Inflationary gap S0 D Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Adjusting to an Inflationary Gap ● During this process, both prices and unemployment are increasing. ● Stagflation = inflation that occurs while the economy is growing slowly or having a recession Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ● Demand Inflation and Stagflation ♦ In an inflationary gap, prices and wages rise because of excess demand. ♦ Rising wages are a symptom, not a cause, of the underlying problem. ♦ A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ● The stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Adjusting to an Inflationary Gap ● The U.S. economy has experienced two episodes of stagflation in the last decade. ♦ The more notable one came between 1988 and 1990 – low unemployment was accompanied by moderate inflation. ♦ A milder version of this same phenomenon occurred in the first half of 1999; however, inflation was generally held in check. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Stagflation from a Supply Shock ● Independent shifts inward in aggregate supply are a second cause of stagflation. ● The increase in world oil prices caused such a shift twice in the 1970s. ● Favorable supply shocks tend to push output up and reduce inflation. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 26-7 Stagflation from an Advance Shift in AS FIGURE D S1 Price Level (1996 = 100) S0 A 40.0 33.6 E S1 S0 D 4,099 4,123 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Inflation and the Multiplier ● Inflation size of the multiplier ● As long as the aggregate supply curve is upward sloping, AD price level ● This, in turn, drains off some of the higher real demand. ♦ purchasing power of consumer wealth ♦ net exports Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 26-8 Inflation and the Multiplier FIGURE D1 D0 Price Level S $800 billion 120 E1 E0 100 A S D0 D1 6,000 6,600 6,800 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. A Role for Stabilization Policy ● Since the economy’s self-correcting mechanism sometimes works slowly, there is room for government stabilization policy to improve the workings of the free market. Copyright© 2003 Southwestern/Thomson Learning All rights reserved.