chapter 15 long-run macroeconomic adjustments · pdf filechapter 15 long-run macroeconomic...

CHAPTER 15

Long-Run Macroeconomic

Adjustments

1

PART 5: THE LONG RUN AND

CURRENT ISSUES IN MACRO

THEORY AND POLICY

Slides prepared by Bruno Fullone, George Brown College

© 2010 McGraw-Hill Ryerson Limited

• Learning Objective 15.1: How the economy arrives at its long-run equilibrium

• Learning Objective 15.2 : How to apply the long-run AD–AS model to explain inflation, recessions, and growth

• Learning Objective 15.3 About the short-run tradeoff between inflation and unemployment (the Phillips Curve)

• Learning Objective 15.4 : Why there is no long-run tradeoff between inflation and unemployment

• Learning Objective 15.5 : The relationship among tax rates, tax revenues, and aggregate supply

2

In This Chapter You Will Learn

• Short run

– Input prices are inflexible

– aggregate supply curve is upwardly sloping

• Long run

– Input prices are fully flexible

– Vertical aggregate supply

• The transition?

3

15.1 From the Short Run to

the Long Run

• Production above potential output:

– High demand for inputs

– Input prices rise

– Short run aggregate supply shifts left

– Return to potential output

• Production below potential output

• Graphical examples…

LO15.1 4

Short-Run AS to the Long-Run AS

GDPf GDP2 GDP3

P3

P1

P2

P3

P1

P2

AS1

Real Domestic Output Real Domestic Output

GDPf

Short-Run Aggregate Supply

Long-Run Aggregate Supply

a1

a2

a3

a1

a2

a3

b1

c1

Pri

ce L

ev

el

Pri

ce L

ev

el

AS3

AS2 AS1

ASLR

LO15.1 5

Figure 15-1

From Short-Run to Long-Run

Real Domestic Output

Pri

ce L

ev

el

P1

GDPf

a

AS1 ASLR

AD1

LO15.1 6

Figure 15-2 Equilibrium

in the Long-Run AD-AS Model

LO15.2 7

• Demand-pull inflation occurs when an increase in aggregate demand pulls

up the price level

15.2 Applying the Long-Run

AD-AS Model

LO15.2 8

o

AS1

P1

- Higher demand leads to a higher price level, and higher

output - A higher price level (P2 ) EVENTUALLY leads to higher nominal wages which causes....

AD1

P2

AD2

GDP2

Pri

ce L

ev

el

GDPf

Figure 15-3

Real domestic product

1. The starting

point is full

employment

GDP (GDPf ) 2. AD increase…

ASLR

Demand-Pull Inflation in the Long-Run AD-AS Model

LO15.2 9

o

AS1

P1

P3

GDP2

AD2

- A left shift of

the short run

AS curve

- Real output

then return to

its prior level

and the price

rises even

more

AS2

P2

AD1 P

rice L

ev

el

GDPf

Figure 15-3


ASLR

Demand-Pull Inflation in the Long-Run AD-AS Model

LO15.2 10

• In the short run, demand-pull inflation drives up prices and output

• In the long run, output is restored to GDPf and only the price level is higher

LO15.2 11

• In the short run, demand-pull inflation drives up prices and output

• In the long run, output is restored

to GDPf and only the price level is higher

Demand-Pull Inflation

Real Gross Domestic Product

Pri

ce L

ev

el

P1

GDPf

a

AS1 ASLR

AD1

AD2

AS2

b

c P2

P3

GDP2

LO15.2

Demand-Pull Inflation in the

Long-Run AD-AS Model

LO15.2 13

• Cost-push inflation arises from factors

that increase the cost of production at each price level

Cost-Push Inflation

LO15.2 14

o

AS1

P1

Cost-push

inflation

occurs

when AS

shifts to the

left, leading

to higher

prices and

lower output

AD1

AS2

P2

Pri

ce L

ev

el

Figure 15-4

GDP2 GDPf

ASLR


Cost-Push Inflation in the Long-Run AD-AS Model

LO 15.2 15

o

AS1

P1

Layoffs, high

unemployment

will eventually

lead to lower

factor prices

AD1

AS2

P2

Pri

ce L

ev

el

Figure 15-4

GDPf GDP2

ASLR



LO15.2 16

o

AS1

P1

Expansionary

fiscal or

monetary policy

AD1

AS2

P2

AD2

P3

Pri

ce L

ev

el

Figure 15-4

GDPf GDP2

ASLR


Leads to high Inflation


LO15.2 17

• If government attempts to maintain full employment, an inflationary spiral may occur

• Otherwise, the recession will linger, with high unemployment and a loss of real output

Cost-Push Inflation: Policy Dilemma

LO15.2 18

o

AS2

P3

AD2

AS1

P2

AD1

P1

Pri

ce L

ev

el

Figure 15-5

GDPf GDP1

ASLR


Recession Occur

AD1 – AD2, P1 – P2, GDPf – GDP1

Lower wage

AS1-AS2, restore GDP, P2 further Reduce to P3

Recession in the Long-Run AD-AS Model

LO15.2 19

• How long would it take in the real world for price & wage adjustments to occur to regain full employment?

• There is disagreement among economists

Recession and the Long-Run

AD-AS Model

• modern economies tend to experience positive rates of inflation due to

• economic growth causing rightward shifts of the AS curve

• central banks then cause rightward shifts of the AD curve so that it proceeds just a little faster than the deflationary rightward shifts of the AS curve

• the net effect is (usually) a small positive rate of inflation

20 LO15.2

Ongoing Inflation in the Long-Run

AD-AS Model

21

• economic growth causes increases in long-run aggregate supply

• whether deflation, or inflation accompanies growth depends on the extent to which aggregate demand increases relative to aggregate supply

• any inflation that occurs is the result of growth of aggregate demand

• it is not the result of the growth of real GDP

LO15.2

Long-Run AD-AS Model

LO 15.3 22

• Under normal circumstances, there is a short-run tradeoff between inflation & unemployment

• Aggregate supply shocks can cause both higher inflation & higher unemployment

• There is no significant tradeoff between inflation & unemployment over long periods of time

The Inflation-Unemployment

Relationship

LO15.3 23

• Assuming a constant AS, high rates of inflation are accompanied by low rates of unemployment, & vice-versa

illustrated…

The Phillips Curve

LO15.3 24

o

P0

P1

P2

P3

GDP0 GDP1 GDP2 GDP3

AD0

AD1

AD2

AD3

AS

Figure 15-9 P

rice L

ev

el


The SR Effects of Changes in AD on Real Output

and the Price Level

LO15.3 25

0

1

2

3

4

5

6

7

8

0 1 2 3 4 5 6 7 8

Unemployment Rate

Infla

tio

n

Figure 15-8

61

66 67

68 69

65 64 63

62

A Negative relationship between inflation and unemployment

Phillips Curve: Concepts and Canadian Data

LO15.3 26

• Modern economists reject the idea of a stable, predictable long-run Phillips Curve

• They agree there is a short-run tradeoff between inflation & unemployment

The Phillips Curve

LO15.3 27

• In the late 1970s and early 1980s, the economy experienced stagflation

Aggregate Supply Shocks and

the Phillips Curve

LO15.3 28

• OPEC and Energy Prices

• Other shocks:

– agricultural shortfalls

– dollar depreciation

– wage increases after wage-price controls lifted

– declining productivity

Adverse Aggregate Supply Shocks

LO15.3 29

Figure 15-10: Inflation Rates and Unemployment

Rates in Canada

LO15.4 30

• by the late ‘80s, it appeared the Phillips curve had shifted back

– recession of ‘81-’83

– increased foreign competition

– deregulation of airlines and trucking

– decline in OPEC’s power

• these factors also helped to reduce per-unit production costs and to shift the short-run AS

curve rightward

Stagflation’s Demise

LO15.4 31

• There is no apparent long-run tradeoff between inflation & unemployment

15.4 The Long-Run Phillips Curve

LO15.4 32

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PC1

a1

PCLR

Unemployment rate (percent)

0

3

6

9

12

15 Figure 15-11

Economy is at a1 with

unemployment at 5%,

and inflation at 3%;

suppose wages are set

on the assumption of

3% inflation

The Long-Run Phillips Curve

LO15.4 33

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15 Suppose AD increases

& inflation increases to

6%; economy moves to

b1

b1

Figure 15-11


LO15.4 34

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15 But b1 is not a stable

equilibrium; workers will

demand higher wages;

economy moves to a2

b1

a2

Figure 15-11


LO15.4 35

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15 Phillips Curve shifts

upward from PC1 to PC2

b1

a2

PC2

Figure 15-11


LO15.4 36

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15 Scenario repeats if AD

increases again

b1

a2

PC2

b2 a3

PC3

So any rate of inflation

is possible with the 5%

natural rate of

unemployment

Figure 15-11


LO15.4 37

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15

b1

a2

PC2

b2 a3

PC3

The long-run Phillips

Curve is vertical at the

5% natural rate of

unemployment

Figure 15-11


LO15.4 38

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PCLR


a3

PC3

0

3

6

9

12

15

c3

What about disinflation?

Suppose the economy

is at a3 & AD declines

Figure 15-11


LO15.4 39

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PCLR


a3

PC3

0

3

6

9

12

15

c3

Firms & workers

eventually adjust to

lower 6% inflation PC2

a2

Figure 15-11


LO15.4 40

An

nu

al

rate

of

infl

ati

on

(pe

rce

nt)

3 4 5 6

PCLR


a3

PC3

0

3

6

9

12

15

c3

If AD falls further, the

scenario will continue PC2

a2

c2

PC1

a1

Figure 15-11


LO15.5 41

• Government policies can impede or promote rightward shifts of AS

• Effects of taxation on the supply curve are key concerns of supply side economics

15.5 Taxation and Aggregate

Supply

LO15.5 42

• Reductions in marginal tax rates on earned incomes induce more work

• Lower marginal tax rates make leisure relatively more expensive

Taxes and Incentives to Work

LO15.5 43

• Lower marginal tax rates increase the rewards for saving & investing

• Saving is a prerequisite for investment

Incentives to Save and Invest

LO15.5 44

• It is possible that reductions in marginal tax rates will increase AS but leave tax revenues unchanged

illustrated…

The Laffer Curve

Tax revenue (dollars)

0

100

Shows impact of tax rates

upon tax collections

Ta

x r

ate

(p

erc

en

t)

Figure 15-12

Maximum Tax

Revenue

Lower Tax Revenue

Above m

m

45 LO15.5

The Laffer Curve

LO15.5 46

• Taxes, Incentives and Time

• empirical evidence shows the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge

• Inflation

– demand side effects may be greater/quicker and certain

• Position on Curve

– where are we?

Criticisms of the Laffer Curve

The Last Word: Do Tax Increases

Reduce Real GDP?

• New findings suggest tax increases reduce real GDP (Romer and Romer 2008)

• Positive output shocks raise tax revenues

• Difficult to separate effects of tax changes from other effects

• Investment falls sharply in response to tax changes

15.1 From the short run to the long run

15.2 Applying the long-run AD–AS model

15.3 The inflation–unemployment relationship

15.4 The long-run Phillips curve

15.5 Taxation and aggregate supply

48 chapter 15

Chapter 15 Summary

chapter 15 long-run macroeconomic adjustments · pdf filechapter 15 long-run macroeconomic...

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