26 supply-side equilibrium: unemployment and inflation? we might as well reasonably dispute whether...

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

● The Aggregate Supply Curve

● Equilibrium of Aggregate Demand and Supply

● Recessionary and Inflationary Gaps Revisited

● Adjusting to a Recessionary Gap: Deflation or Unemployment?

● The Aggregate Supply Curve

● Equilibrium of Aggregate Demand and Supply

● Recessionary and Inflationary Gaps Revisited

● Adjusting to a Recessionary Gap: Deflation or Unemployment?

ContentsContents

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

● Adjusting to an Inflationary Gap: Inflation

● Stagflation from a Supply Shock

● Inflation and the Multiplier

● A Role for Stabilization Policy

● Adjusting to an Inflationary Gap: Inflation

● Stagflation from a Supply Shock

● Inflation and the Multiplier

● A Role for Stabilization Policy

Contents (continued)Contents (continued)


Copyright© 2003 Southwestern/Thomson Learning All rights reserved.

The Aggregate Supply CurveThe 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.

● 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.

FIGURE 26-1 An Aggregate Supply Curve

FIGURE 26-1 An Aggregate Supply Curve


Pri

ce L

evel

Real GDP

S

S



● 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.

● 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.



● 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

● 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

FIGURE 26-2 A Shift of the Aggregate Supply Curve

FIGURE 26-2 A Shift of the Aggregate Supply Curve


S1

S1 (higher wages)

S0

S0 (lower wages)

100

6,000

Pri

ce

Lev

el

5,500 Real GDP

A B



● Shifts of the Aggregate Supply Curve cost of production inward shift of AS

curve■Money wage rate■Interest rate■Materials prices

● Shifts of the Aggregate Supply Curve cost of production inward shift of AS

curve■Money wage rate■Interest rate■Materials prices


● 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

● 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



Equilibrium of Aggregate Demand and SupplyEquilibrium of Aggregate Demand and Supply

● Price level adjustments AS-AD equilibrium

● Imbalance between AS and AD inventories price quantity of AS and AD

● Price level adjustments AS-AD equilibrium

● Imbalance between AS and AD inventories price quantity of AS and AD

FIGURE 26-3 Equilibrium of Real GDP and the Price Level

FIGURE 26-3 Equilibrium of Real GDP and the Price Level


Pri

ce L

evel

90

130

110

80

120

D

D S

S

100

6,400 6,800 5,200 5,600 6,000 Real GDP

E

TABLE 26-1 Determination of the Equilibrium Price Level

TABLE 26-1 Determination of the Equilibrium Price Level



● 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

● 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

Recessionary and Inflationary Gaps RevisitedRecessionary and Inflationary Gaps Revisited


Recessionary and Inflationary Gaps RevisitedRecessionary and Inflationary Gaps Revisited

● Long-run: market forces make equilibrium GDP = potential GDP

● Long-run: market forces make equilibrium GDP = potential GDP

FIGURE 26-5 The Elimination of a Recessionary Gap

FIGURE 26-5 The Elimination of a Recessionary Gap


100

5,000

Recessionary gap

S0

S0

D

D

Potential GDP

Pri

ce L

evel

6,000

Real GDP

E

S1

S1

F

B


Adjusting to a Recessionary GapAdjusting to a Recessionary Gap

● When unemployment exists, if money wages fall: ♦ The aggregate supply curve will shift outward

♦ Full employment will be attained eventually

● When unemployment exists, if money wages fall: ♦ The aggregate supply curve will shift outward

♦ Full employment will be attained eventually


● In the real economy, however, wage reductions are slow and uncertain, particularly in the post-World War II period.

● In the real economy, however, wage reductions are slow and uncertain, particularly in the post-World War II period.




● 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

● 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



● With sticky wages, cyclical unemployment may last a long time.

● With sticky wages, cyclical unemployment may last a long time.



● 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.

● 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.



● 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?

● 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?


Adjusting to an Inflationary GapAdjusting 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

● 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

FIGURE 26-6 The Elimination of an Inflationary Gap

FIGURE 26-6 The Elimination of an Inflationary Gap


S1

S1

S0

S0

D

D

Real GDP

Pri

ce

Le

ve

l

E

Inflationary gap

Potential GDP

F

B



● During this process, both prices and unemployment are increasing.

● Stagflation = inflation that occurs while the economy is growing slowly or having a recession

● During this process, both prices and unemployment are increasing.

● Stagflation = inflation that occurs while the economy is growing slowly or having a recession



● 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.

● 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.



● The stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP.

● The stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP.



● 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.

● 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.


Stagflation from a Supply ShockStagflation 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.

● 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.

FIGURE 26-7 Stagflation from an Advance Shift in AS

FIGURE 26-7 Stagflation from an Advance Shift in AS


40.0

33.6

4,099

Pri

ce

Le

ve

l (1

99

6 =

10

0)

4,123

Real GDP

D

D

S1

S1

S0

S0

A

E


● 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

● 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

Inflation and the MultiplierInflation and the Multiplier

FIGURE 26-8 Inflation and the Multiplier

FIGURE 26-8 Inflation and the Multiplier


S

S

$800

billion

D1

D1

6,000

120

100

6,600

A

D0

D0

Pri

ce L

evel

6,800

Real GDP

E0 E1


● 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.

● 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.

A Role for Stabilization PolicyA Role for Stabilization Policy

26 supply-side equilibrium: unemployment and inflation? we might as well reasonably dispute whether...

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