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
Real domestic product
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
Real domestic product
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
Real domestic product
Cost-Push Inflation in the Long-Run AD-AS Model
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
Real domestic product
Leads to high Inflation
Cost-Push Inflation in the Long-Run AD-AS Model
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
Real domestic product
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
Real domestic product
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
Unemployment rate (percent)
0
3
6
9
12
15 Suppose AD increases
& inflation increases to
6%; economy moves to
b1
b1
Figure 15-11
The Long-Run Phillips Curve
LO15.4 34
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 But b1 is not a stable
equilibrium; workers will
demand higher wages;
economy moves to a2
b1
a2
Figure 15-11
The Long-Run Phillips Curve
LO15.4 35
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 Phillips Curve shifts
upward from PC1 to PC2
b1
a2
PC2
Figure 15-11
The Long-Run Phillips Curve
LO15.4 36
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 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
The Long-Run Phillips Curve
LO15.4 37
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
b1
a2
PC2
b2 a3
PC3
The long-run Phillips
Curve is vertical at the
5% natural rate of
unemployment
Figure 15-11
The Long-Run Phillips Curve
LO15.4 38
An
nu
al
rate
of
infl
ati
on
(pe
rce
nt)
3 4 5 6
PCLR
Unemployment rate (percent)
a3
PC3
0
3
6
9
12
15
c3
What about disinflation?
Suppose the economy
is at a3 & AD declines
Figure 15-11
The Long-Run Phillips Curve
LO15.4 39
An
nu
al
rate
of
infl
ati
on
(pe
rce
nt)
3 4 5 6
PCLR
Unemployment rate (percent)
a3
PC3
0
3
6
9
12
15
c3
Firms & workers
eventually adjust to
lower 6% inflation PC2
a2
Figure 15-11
The Long-Run Phillips Curve
LO15.4 40
An
nu
al
rate
of
infl
ati
on
(pe
rce
nt)
3 4 5 6
PCLR
Unemployment rate (percent)
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
The Long-Run Phillips Curve
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