chapter 10
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Chapter 10. 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. Why AS?. - PowerPoint PPT PresentationTRANSCRIPT
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Chapter 10
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
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Why AS?
• Chapter 9 tells us change in AD will create inflationary gap vs. recessionary gap
• Which sort of gap will arise?• Need to know priceprice level• AS + AD determine price level• This chapter: bring the supplysupply side back
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The Aggregate Supply Curve
• Aggregate supply curve– Each possible price level
– Quantity of goods & services
– All nation’s businesses - willing to produce
– Specified period of time
– All other determinants – constant
• Aggregate supply curve– Slopes upwardupward
3
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An aggregate supply curve
Figure 1
4
Real GDP
Pric
e Le
vel
S
S
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The AS Curve: Why Upward Slope?
• Unit profit = Price – Unit cost• Aggregate supply curve - slopes upward
– Firms – purchase inputs• Prices – fixed for some period of time
– Higher selling prices – output • Production – more attractive
• Aggregate supply curve– Shifts outward/right
– More output produced• Any given price level 5
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The Aggregate Supply Curve
• Aggregate supply curve– Nominal wage rateNominal wage rate – increase
• Higher real production costs• Aggregate supply curve – shifts inward/left
– Prices of other inputsPrices of other inputs – increase • Higher real production costs• Aggregate supply curve – shifts inward/left
6
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A shift of the aggregate supply curve
Figure 2
7
0
Real GDP (Y)
Pric
e Le
vel (
P)
6,0005,500
S0 (lower wages)
S0
S1 (higher wages)
S1
100A
B
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The Aggregate Supply Curve
• Aggregate supply curve– Technology & productivityTechnology & productivity – improve
• Decrease business costs• Aggregate supply curve – shift outward/right
– Available supply of labor & capitalAvailable supply of labor & capital – better • Labor force - grows or improves in quality• Capital stock – increases (investment)• Aggregate supply curve – shifts outward/right
8
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Equilibrium: Aggregate Demand & Supply
• Equilibrium GDP– AD curve intersects AS curve
– Equilibrium price level
– Equilibrium quantity
9
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Equilibrium of real GDP and the price level
Figure 3
10
5,200 5,6000 6,000 6,400
Real GDP (Y)
6,800
80
90
100
110
Pric
e Le
vel (
P)
120
130 D
DS
S
E
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Equilibrium: Aggregate Demand & Supply
• For price level > Equilibrium price level– Aggregate quantity supplied exceeds
• Aggregate quantity demanded
– Inventories – increase• Prices – forced down
– Price level – falls
– Production – falls
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Equilibrium: Aggregate Demand & Supply
• For price level < Equilibrium price level– Aggregate quantity demanded exceeds
• Aggregate quantity supplied
– Shortage of goods
– Inventories – decrease• Prices – increase
– Price level – rise
– Production – rise
12
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Determination of the equilibrium price level
Table 1
13
(1) (2) (3) (4) (5)
PriceLevel
AggregateQuantity
Demanded
AggregateQuantitySupplied
Balance of Supplyand Demand
Prices will be:
8090
100110120
$6,4006,2006,0005,8005,600
$5,6005,8006,0006,2006,400
Demand exceeds supplyDemand exceeds supplyDemand equals supplySupply exceeds demandSupply exceeds demand
RisingRising
UnchangedFallingfalling
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Inflation and the Multiplier
• Aggregate supply curve – slopes upward– Any increase in aggregate demand
• Price level – increase • Erodes purchasing power of consumer wealth• Reduces net exports
– Inflation – reduces value of multiplier
14
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Inflation and the multiplier
Figure 4
15
0 6,000 6,400
Real GDP (Y)
6,800
80
90
100
110
Pric
e Le
vel (
P)
120
130 D0
D0
S
S
D1
D1
A
$800
billion
E1
E0
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Recessionary & Inflationary Gaps
• Recessionary gap– Equilibrium GDP < Potential GDP
– Aggregate demand – weak
• Inflationary gap– Equilibrium GDP > Potential GDP
– Excess aggregate demand
16
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Recessionary and inflationary gaps revisited
Figure 5 (a)
17
Real GDP
Rea
l Exp
endi
ture45°
C+I0+G+(X-IM)
6,000 7,000
Potential GDP
B
E
Recessionary gap
0 Real GDP
Pric
e Le
vel
Recessionary gap
6,000 7,000
Potential GDP
B
S
S
D0
D0
E
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Recessionary and inflationary gaps revisited
Figure 5 (b)
18
Real GDP
Rea
l Exp
endi
ture45°
C+I1+G+(X-IM)
7,000
Potential GDP
E
0 Real GDP
Pric
e Le
vel
7,000
Potential GDP
S
S
D1
D1E
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Recessionary and inflationary gaps revisited
Figure 5 (c)
19
Real GDP
Rea
l Exp
endi
ture45°
C+I2+G+(X-IM)
8,0007,000
Potential GDP
BE
Inflationary
gap
0 Real GDP
Pric
e Le
vel
Inflationary
gap
8,0007,000
Potential GDP
BS
S D2
D2 E
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Adjusting to a Recessionary Gap
• Recessionary gap
cyclical unemployment wage AS curve shifts outwardoutward
Y, P• It is a self-correcting mechanismself-correcting mechanism
20
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The elimination of a recessionary gap
Figure 6
21Real GDP (Y)
Pric
e Le
vel (
P)
Recessionary
gap
5,000 6,000
Potential
GDP
B
S0
S0
D
DS1
S1
F
E
100
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Adjusting to a Recessionary Gap
• In reality, wages & prices rarely fall– Institutional factors: minimum wage law,
union contracts
– Psychological resistance to wage reduction
– Business cycles – less severe
– Firms – don’t want to lose best employees
• Economy - get stuck– Recessionary gap - long period
22
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Adjusting to Inflationary Gap: Inflation
• Inflationary gap
over employment
wage AS shifts inwardinward
Y, P • Again, it is a self-correctingself-correcting mechanism
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The elimination of an inflationary gap
Figure 7
24
Real GDP (Y)
Pric
e Le
vel (
P)
Inflationary
gap
Potential
GDP
B
S0
S0
D
DS1
S1
F
E
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Adjusting to Inflationary Gap: Inflation
• Self-correcting mechanism– Takes time
• Stagflation– Inflation and economic stagnation
– Normal – after excessive aggregate demand
25
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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
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Stagflation from an adverse shift in aggregate supply
Figure 8
27
S0
S0
D
D
S1
S1
A
Real GDP
Pric
e Le
vel
(200
0=10
0)
4,3424,275
31.836.0 E
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Applying Model to a Growing Economy
• Simple model– Aggregate demand
– Aggregate supply
– Equilibrium price level
– Equilibrium level of real GDP
• U.S. : price level & real GDP, 1972-2007– Higher price level
– Higher GDP
– Growth & Inflation28
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The price level & real GDP output in U.S., 1972–2007
Figure 9
29
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Applying Model to a Growing Economy
• Every year– Aggregate demand – grows
• Shift right• Growing population
– More demand: consumer & investment goods
• Increased government purchases
– Aggregate supply – shift right• More workers• Investment & technology
– Improve productivity
30
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Aggregate supply & demand analysis: growing economy
Figure 10
31
S0
S0 D0
D0
Real GDP (Y) in Billions of 2000 Dollars
Pric
e Le
vel (
P)
(200
0=10
0)
11,000 11,330
113
116.5
A
D1
D1
S1
S1
B
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Applying Model to a Growing Economy
• Demand-side fluctuations– For Aggregate supply – grows, and
• If: Aggregate demand – grows faster– Faster growth– More inflation– Economic boom
• If: Aggregate demand – grows slower– Slower growth– Less inflation– Economic recession
32
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The effects of faster growth of aggregate demand
Figure 11
33
S0
S0 D0
D0
Real GDP (Y) in Billions of 2000 Dollars
Pric
e Le
vel (
P)
(200
0=10
0)
11,000 11,500
113
120
A
D2
D2
S1
S1
C
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The effects of slower growth of aggregate demand
Figure 12
34
S0
S0 D0
D0
Real GDP (Y) in Billions of 2000 Dollars
Pric
e Le
vel (
P)
(200
0=10
0)
11,000 11,165
113115 A
D3
D3
S1
S1
E
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Applying Model to a Growing Economy
• Supply-side fluctuations– For Aggregate demand – grows, and
• If: Aggregate supply – shifts inward– Real output – decline slightly– Prices – rapid increase– Stagflation
• If: Aggregate supply – grows faster– Favorable supply shock– Faster economic growth– Lower inflation
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Stagflation from an adverse supply shock
Figure 13
36
S0
S0
D0
D0
S1
S1
Real GDP (Y) in Billions of 2000 Dollars
Pric
e Le
vel
(200
0=10
0)
4,3424,311
31.8
39.0
ED1
D1 B
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The effects of a favorable supply shock
Figure 14
37
Real GDP (Y)
Pric
e Le
vel (
P)
S0
S0 D0
D0
A
D1
D1
S1
S1
B
C
Normal growth
of aggregate supply
Effect of favorable
supply shock
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Big Picture
• Chapter 8: compositioncomposition of AD and the volatility of investment
• Chapter 9: changes in investment have multipliermultiplier effects on AD (given price)
• This chapter: show how shifts in AD curve cause fluctuations in both GDPGDP and priceprice
38
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A Role For Stabilization Policy
• Economy’s self-correcting mechanism– Works slowly
• Government stabilization policy– Improve workings of free market
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Summary
• AS curve: upward slope• Shifts of AS curve• Equilibrium of AS-AD• Self-Correcting Mechanism of
Economy• The process might be slow • Need government stabilization policy