Economics Assignment 2

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Economics: Principles and Policy

William J. Baumol, Alan S. Blinder, John L. Solow

14th edition

Powerpoint Slides prepared by: Philip Heap, James Madison University

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in part.

The Macroeconomy: Aggregate Supply and Demand

Part 2

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Chapter 10

Bringing in the Supply Side: Unemployment and Inflation?

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An Opening Quote

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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Bringing in the Supply Side

• Two main issues to address

1. Does the economy have an efficient self correction mechanism?

2. What causes stagflation?

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The Aggregate Supply Curve 1 of 4

• Aggregate supply curve

• Relationship between the price level and the quantity of real G D P supplied, holding all other determinants of quantity supplied constant

• Positive relationship between price and aggregate quantity supplied

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Figure 1 The Aggregate Supply Curve

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The Aggregate Supply Curve 2 of 4

• Why does the aggregate supply curve slope upwards?

• Firms motivated by profit

• Unit profit = Price – Unit cost

• Unit costs of some inputs are fixed for period of time

▶ Wages fixed by contract, adjust annually

▶ Material input prices set by long term contracts

• As price increases, unit cost remain the same, unit profits increase

• Firms increase supply

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The Aggregate Supply Curve 3 of 4

• What factors cause the aggregate supply curve to shift?

• Holding the price level fixed what causes an increase or decrease in output?

• The nominal wage rate or the money wage rate

• Higher wages cause production costs to increase and profits to fall

• Firms cut back on production

• Aggregate supply decreases or shifts left

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Figure 2 Shifts of the Aggregate Supply Curve

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The Aggregate Supply Curve 4 of 4

• What other factors cause the aggregate supply curve to shift?

• Prices of other inputs

• Same effect on aggregate supply as with wages

• Energy prices; oil

• Technology

• Improves labor productivity and reduces business costs

• Shifts aggregate supply outward or to the right

• Available supplies of labor and capital

• Labor force grows or improves in quality

• Investment in capital stock increases

• Shifts aggregate supply outward or to the right

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Equilibrium of Aggregate Demand and Supply

• Equilibrium price level and G D P

• Occurs where aggregate demand curve intersects aggregate supply curve

• Determines the equilibrium price level

• Aggregate quantity demanded equals aggregate quantity supplied

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Figure 3 Equilibrium of Real GDP and the Price Level

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Table 1 Determination of the Equilibrium Price Level

Price Level Aggregate Quantity

Demanded Aggregate

Quantity Supplied Balance of Supply

and Demand Prices will be:

80 $6,400 $5,600 Demand exceeds

supply Rising

90 6,200 5,800 Demand exceeds

supply Rising

100 6,000 6,000 Demand equals

supply Unchanged

110 5,800 6,200 Supply exceeds

demand Falling

120 5,600 6,400 Supply exceeds

demand Falling

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Inflation and the Multiplier

• What happens to equilibrium G D P if the aggregate demand curve shifts outward?

• From before we learned that the multiplier effect was over simplified

• Variable imports reduced the size of the multiplier

• Inflation reduces the size of the multiplier

• If the aggregate supply curve slopes upward

• Increases in aggregate demand pushes up the price level

• Purchasing power of consumer wealth falls

• Consumer spending and net exports will fall

• So inflation reduces the value of multiplier

• The slope of the aggregate supply curve matters

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Figure 4 Inflation and the Multiplier

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Recessionary and Inflationary Gaps Revisited 1 of 2

• Does equilibrium occur below or above potential G D P?

• Inflationary gap

• Amount by which equilibrium real G D P exceeds the full-employment level of G D P

• Recessionary gap

• Amount by which the equilibrium level of real G D P falls short of potential G D P

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Figure 5 Recessionary and Inflationary Gaps Revisited

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Recessionary and Inflationary Gaps Revisited 2 of 2

• Three possible cases in the aggregate demand aggregate supply model

1. Aggregate demand intersects aggregate supply at potential G D P

• The economy is “just right”

2. Aggregate demand intersects aggregate supply below potential G D P

• There is a recessionary gap

3. Aggregate demand intersects aggregate supply above potential G D P

• There is an inflationary gap

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Adjusting to a Recessionary Gap: Deflation or Unemployment 1 of 5

• What happens when there is a recessionary gap?

• Equilibrium real G D P less than potential G D P

• Cyclical unemployment

• If unemployment persistent, wages may fall

• Aggregate supply increases: shifts outward to the right

• Price level falls and real G D P increases

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Figure 6 The Elimination of a Recessionary Gap

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Adjusting to a Recessionary Gap: Deflation or Unemployment 2 of 5

• What’s the problem in the real world with our story?

• Process can take a long time

• Deflation in U S extremely rare: none since World War 2

• Exception in Japan over last 25 years

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Adjusting to a Recessionary Gap: Deflation or Unemployment 3 of 5

• Why don’t nominal wages and prices fall easily?

• Institutional factors

• Minimum wage, unions, regulations

• U.S. compared to Europe

• Psychological resistance to wage reduction

• Compare: 3% to 1% increase versus 1% to -1%

• Less severe business cycles

• Wait out the bad times rather than accept lower wages

• Firms do not want to lose best employees

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Adjusting to a Recessionary Gap: Deflation or Unemployment 4 of 5

• What is the implication of wage and price rigidity?

• With low aggregate demand, economy can get stuck in recessionary gap for long period

• End up with persistent high unemployment

• What about the self-correcting mechanism?

• Refers to the way money wages react to either a recessionary gap or an inflationary gap

• Wage changes shift the aggregate supply curve and change the equilibrium price and output

• The problem is that the economy will take a long time to recover

• Political implications

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Adjusting to a Recessionary Gap: Deflation or Unemployment 5 of 5

• Deflation worries in the United States

• Two deflationary worries in the 2000s, both related to recessionary gaps

• Underlying inflationary tendencies measured by “core” inflation

• Inflation rate for all items other than food and energy

• To smooth monthly “blips”, consider changes over twelve months

• Core Consumer Price Index or C P I

• Fell steadily in 2002 and 2003: as low as 1.1% by winter 2003-2004

• Inflation also fell below 1% during Great Recession

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Adjusting to an Inflationary Gap: Inflation 1 of 4

• How does economy recover when there is an inflationary gap?

• Equilibrium real G D P exceeds potential G D P

• Labor in great demand, so firms start increasing wages

• Higher wages increase costs, so aggregate supply shifts left

• Economy returns to potential at a higher price level

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Figure 7 The Elimination of an Inflationary Gap

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Adjusting to an Inflationary Gap: Inflation 2 of 4

• Demand inflation and Stagflation

• Demand inflation

• Occurs when there is too much aggregate demand relative to potential G D P

• Too much aggregate demand leads to both higher wages and higher prices

• Not higher wages leads to higher prices

• Stagflation

• Inflation that occurs while the economy is growing slowly or having a recession

• Normal after excessive aggregate demand

• Decrease in aggregate supply leads to inflation

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Adjusting to an Inflationary Gap: Inflation 3 of 4

• Stagflation in the U.S.

• Following long economic expansion of the 1980s

• Unemployment rate: 5% (March 1989)

• Below full employment so inflationary gap

• 1988 - 1990, inflation increased from 4.4% to 4.6% to 6.1%

• 1989 - 1991, real G D P growth fell from 3.5% to 1.9% to -0.5%

• Inflationary gap virtually disappeared by mid 1990

• Recent history

• 2017-2018, unemployment fell to 4%, and still low

• Yet inflation still remains relatively low

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Adjusting to an Inflationary Gap: Inflation 4 of 4

• What can we conclude from discussion of recessionary and inflationary gaps?

• A self-correction mechanism tends to eliminate either gap

• Process works slowly and unevenly

• Positive effects on either inflation or unemployment may be offset by opposing forces

• Therefore, mechanism not always reliable

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Stagflation for a Supply Shock 1 of 2

• Stagflation can have two causes

• A decrease in aggregate supply as economy adjusts to inflationary gap

• Negative shocks due to aggregate supply due to other factors

• Usually, energy prices

▶ 1973, 1979-1980: O PEC restricts oil supply and increases oil prices

▶ 1990: Kuwait

▶ 2002 -2008: Iraq wars, other conflicts in the Middle East, demand from China

▶ Similar problems 2017-2018

• Higher energy rises cause aggregate supply to decrease

▶ Real output falls, and the price level rises

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Figure 8 Stagflation from an Adverse Shift in Aggregate Supply

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Stagflation for a Supply Shock 2 of 2

• Stagflation is the typical result of adverse shifts of aggregate supply curve

• Real output falls and higher inflation

• Why may this be more serious than an adverse aggregate demand shock?

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Applying the Model to a Growing Economy 1 of 6

• From our simple model to the real world

• In real world both the price level and real G D P rise over time

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Figure 9 The Price Level and Real GDP in the United States, 1972–2017

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Applying the Model to a Growing Economy 2 of 6

• Every year both aggregate demand and supply shift right

• Aggregate demand shifts right because

• Population growth leads to more demand for consumer and investment goods

• Increased government purchases

• Aggregate supply shifts right

• More workers

• Investment and technology improve productivity

• Since both real G D P and the price level have increased over time, which shift must be larger?

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Figure 10 Aggregate Supply and Demand Analysis of a Growing Economy

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Applying the Model to a Growing Economy 3 of 6

• Demand side fluctuations

• Why does the growth rate of aggregate demand matter?

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Figure 11 The Effects of Faster Growth of Aggregate Demand

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Figure 12 The Effects of Slower Growth of Aggregate Demand

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Applying the Model to a Growing Economy 4 of 6

• Demand side fluctuations

• Why does the growth rate of aggregate demand matter?

• Holding aggregate supply growth constant

• Faster growth in aggregate demand leads to more inflation and faster growth in real output

• Slower growth in aggregate demand leads to less inflation and slower growth in real output

• Implies that rapid inflation occurs when output grows rapidly

• Generally true, but not always

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Applying the Model to a Growing Economy 5 of 6

• Supply side fluctuations

• What happens when there are adverse or favorable supply shocks?

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Figure 13 Stagflation from an Adverse Supply Shock

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Figure 14 The Effects of a Favorable Supply Shock

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Applying the Model to a Growing Economy 6 of 6

• Supply-side fluctuations

• If fluctuations in economic activity are a result from the supply side

• higher rates of inflation are associated with lower rates of economic growth

• lower rates of inflation are associated with higher rates of economic growth

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A Role for Stabilization Policy

• What have we learned over the last few weeks?

• Investment spending tends to be volatile

• Changes in investment and other spending have multiplier effects on aggregate demand

• Shifts in the aggregate demand curve cause undesirable fluctuations in real G D P and the price level

• Economy’s self-correcting mechanism works, but slowly

• Is there room for government stabilization policy?

• How can the government improve the free market?

• First, fiscal policy

• Then, monetary policy