Transcript AP Econ ch 16-

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