Bringing in the Supply Side: Unemployment and Inflation? 10.

Bringing in the Supply Side: Unemployment and Inflation?

10

Bringing in the Supply Side

• Two main issues to address in this chapter1. Does the economy have an efficient self

correction mechanism?

2. What causes stagflation?

2

The Aggregate Supply (AS) Curve

• Aggregate supply curve• The relationship between the price level and the

quantity of real GDP supplied, all other determinants constant

• As the price level rises businesses are willing to produce more

• As the price level falls businesses are willing to produce less

3

Figure 1 An Aggregate Supply (AS) Curve

4

Real GDP

Pric

e Le

vel

S

S

Why does this relationship between the price level and real GDP exist?

What variables are held constant when deriving this relationship?

The Aggregate Supply (AS) Curve• Why does the aggregate supply curve slope

upwards?• Firms motivated by profit

• Unit profit = Price – Unit cost P = $10 and Unit cost = $5 = > profit = $5

• Unit costs of inputs are assumed to be fixed for period of time – the short-run

• Higher selling prices for output makes production more attractive

• The largest input cost is the cost of labor – nominal wages and salaries. We assume this to be fixed in the short-run

5

Shifts of the Aggregate Supply (AS) Curve

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

• The nominal wage rate – money wage rate• Higher wages cause production costs to increase and

profits to fall• Firms cut back on production• Decrease in AS – curve shifts to left.

• The nominal wage rate – money wage rate• Lower wages cause production costs to decrease and

profits to increase• Firms increase production• Increase in AS – curve shifts to right.

6

A Shift of the Aggregate Supply Curve Decrease in AS

7

0

Real GDP (Y)

Pric

e Le

vel (

P)

6,0005,500

S0 (initial wages)

S0

S1 (higher wages)

S1

100A

B

Shifts of the Aggregate Supply (AS) Curve

• Prices of other inputs • Same effect on aggregate supply as with wages• If other input cost increase, AS decrease.• If other input cost decrease, AS increase• What happened to the aggregate supply in fall 2014:

• It increased (shifted right) as energy prices fell

• Technology• Improves labor productivity and reduces business

costs• So improvements in technology shift aggregate supply

outward (right)

8

Figure 2 A Shift of the Aggregate Supply Curve

9

0

Real GDP (Y)

Pric

e Le

vel (

P)

6,000 6,500

S0

S0

S1

S1

100A B

Improvements in technology or decreasein world oil prices

Shifts of the Aggregate Supply (AS)

• Available supplies of labor and capital• Labor force grows or improves in quality

over time• Capital stock increases (investment) over

time• Aggregate supply curve shifts outward

(right)

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Equilibrium of Aggregate Demand and Supply

• Equilibrium GDP• 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

12

5,200 5,6000 6,000 6,400

Real GDP (Y)

6,800

80

90

100

110

Pric

e Le

vel (

P)

120

130D

DS

S

EWhat happens when P = 120?

Equilibrium

• When P > P* (P = 120)• Aggregate quantity supplied exceeds aggregate

quantity demanded

• Firms unable to sell goods so inventories increase

• Production falls and firms decrease prices

13

Figure 3 Equilibrium of Real GDP and the Price Level

14

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

What happens when P = 80?

Equilibrium

• When P < P* (P = 80)• Aggregate quantity demanded exceeds aggregate

quantity supplied

• Firms inventories run down and shortage of goods

• Production increases and firms increase prices

15

Inflation and the Multiplier• How do rising prices affect the size of the

multiplier?• Simple multiplier = 1 / (1 – MPC)• Base on a simple story: spending by one

person is another person’s income . . . • And, prices are assumed constant

• If the aggregate supply curve slopes upward• Increase in aggregate demand pulls up the price

level• Purchasing power of consumer wealth falls and

drains off some of the higher real demand• Inflation reduces the value of multiplier 16

Inflation and the Multiplier

17

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

$800billion

E1

E0

MPC1

1Multiplier Simple

Recessionary and Inflationary Gaps

• Does equilibrium occur below or above potential GDP?

• Recessionary gap• Amount by which the equilibrium level of real

GDP falls short of potential GDP• Caused by weak aggregate demand

• Inflationary gap• Amount by which equilibrium real GDP exceeds

the full-employment level of GDP• Caused by excess aggregate demand

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Figure 5(a) Recessionary and Inflationary Gaps Revisited

19

Real GDP

Rea

l Exp

endi

ture

45°

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

Figure 5(b) Recessionary and Inflationary Gaps Revisited

20

Real GDP

Rea

l Exp

endi

ture

45°

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

Figure 5(c)

Recessionary and Inflationary Gaps Revisited

21

Real GDP

Rea

l Exp

endi

ture

45°

C+I2+G+(X-IM)

8,0007,000

Potential GDP

BE

Inflationary gap

0 Real GDP

Pric

e Le

vel

Inflationarygap

8,0007,000

Potential GDP

BS

S D2

D2 E

Adjusting to a Recessionary Gap

• Deflation or Unemployment?• What happens when there is a recessionary gap?

• Equilibrium real GDP less than potential GDP• Cyclical unemployment• If unemployment persistent, wages will

eventually fall (question is how fast?)• Aggregate supply increases: shifts outward (right)• Price level falls and real GDP increases• This process is called the “self-correcting”

mechanism

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Figure 6 The Elimination of a Recessionary Gap

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Real GDP (Y)

Pric

e Le

vel (

P)

Recessionarygap

5,000 6,000

Potential GDP

B

S0

S0

D

DS1 Lower wages

S1

F

E

100


• Deflation reduces the recessionary gap, bring economy back to potential

• Important catch?• This “self-correcting” process could take a

long time• Japan for last 20 years

24


• Why nominal wages and prices won’t fall (easily)

• Economist speak: “Why are nominal wages and prices rigid”?

• Institutional factors• Minimum wage, unions, regulations• U.S. compared to Europe

• Psychological resistance to wage reduction• Less severe business cycles

• Wait out the bad times rather than accept lower wages

• Firms do not want to lose best employees25


• Implications of wage and price rigidity?• With low aggregate demand, economy can get stuck in

recessionary gap for long period

• Self-correcting mechanism:• Refers to the way money wages and prices react

to either a recessionary gap or an inflationary gap

• Wage changes shift the AS curve• The economy will eventually recover to full

employment• But, how long will the process take?• Political implications! 26


27

Year Recessionary gap (% of GDP)

Change in Inflation in percentage points

1975 4.3 -2.6

1981 7.0 -3.4

1983 5.5 +1.0

1991 3.1 -1.2

2008 2.7 0

2009 7.1 -0.6

2010 6.1 -0.7

2011 5.8 +0.7

2012 4.6 +0.4

2013 4.5 -03

Question: What is the shortcoming of this type of analysis?

Figure 2 Actual and Potential GDP in U.S.

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Adjusting to an Inflationary Gap

• How does economy recover when there is an inflationary gap?• Equilibrium real GDP exceeds potential GDP.• Labor in great demand, so firms start increasing

wages• Higher wages increase costs, so aggregate supply

shifts left• Economy returns to potential GDP at a higher price

level

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Figure 7 The Elimination of an Inflationary Gap

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Real GDP (Y)

Pric

e Le

vel (

P)

Inflationarygap

Potential GDP

B

S0

S0

D

DS1

S1

F

E

Adjusting to an Inflationary Gap• Some lessons about inflation in the real

world• Inflation can result when there is too much

aggregate demand relative to potential GDP, called demand-pull inflation.

• Inflation can also result as the economy adjusts and AS decreases, called cost-push inflation.

• Stagflation• Inflation that occurs while the economy is

growing slowly or having a recession• A stagnating economy with inflation

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Adjusting to an Inflationary Gap

• What can we conclude from discussion of recessionary and inflationary gaps?• A self-correction mechanism tends to eliminate

either recessionary or inflationary gap• It represents the adjustment process of the

economy to reach full employment• But, the process works slowly and

unevenly• Many economist do not think it’s a good idea to

wait around for the process to complete – it may take 20 years.

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Stagflation from a Supply Shock

• What caused high unemployment and inflation in 1970s and early 1980s?• Classic example of stagflation• 1973, 1979-1980 and OPEC• “Oil shocks” causes aggregate supply to

shift left

33

Stagflation from an Adverse Shift in Aggregate Supply - Increase in world Oil price

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S0 1973

S0

D

D

S1 1975

S1

A

Real GDP

Pric

e Le

vel

(200

9=10

0)

5,4185,379

2631 E

What is the %-change in P?What is the %-change in RGDP?

Stagflation from a Supply Shock

• Stagflation is the typical result of adverse shifts of aggregate supply curve• Cost-push inflation• Real output falls and higher inflation

• Adverse aggregate supply shock is more serious than an adverse aggregate demand shock. We will see why in the next chapter.

35

Applying the Model to a Growing Economy

• From our simple model to the real world• In real world both the price level and RGDP rise over time

36

Figure 9 The Price Level and Real GDP Output in the United States, 1972–2013

37

Applying the Model

• Every year both aggregate demand and supply shift right• Aggregate demand shifts right because

• Population grows• More demand for consumer and investment goods• Increased government purchases

• Aggregate supply shifts right• More workers, labor force grows• Investment (more capital) and technology improve

productivity

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Figure 10 Aggregate Supply and Demand Analysis of a Growing Economy

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S0

S0 D0

D0

Real GDP (Y) in Billions of 2009 Dollars

Pric

e Le

vel (

P)

(200

9=10

0)

15,450 15,760

105

106.6 A: 2012

D1

D1

S1

S1

B: 2013

Applying the Model

• Demand-side fluctuations• What happens if the aggregate demand grows faster or

slower than before?

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Figure 11 The Effects of Faster Growth of Aggregate Demand

41

S0

S0 D0

D0


Pric

e Le

vel (

P)

(200

9=10

0)

15,450 16,070

105

107.6A D2

D2S1

S1

C

Higher output and higher inflation.

Figure 12 The Effects of Slower Growth of Aggregate Demand

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S0

S0 D0

D0


Pric

e Le

vel (

P)

(200

9=20

05)

15,450 15,600

105105.5 A

D3

D3

S1

S1

E

Applying the Model

• 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

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Applying the Model

• Supply-side fluctuations• What happens when there are adverse or positive supply

shocks?

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Figure 13 Stagflation from an Adverse Supply Shock

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S0

S0

D0

D0

S1

S1


Pric

e Le

vel

(200

9=10

0)

5,4185,379

26

31

AD1

D1 B

Figure 14 The Effects of a Favorable Supply Shock

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Real GDP (Y)

Pric

e Le

vel (

P)

S0

S0 D0

D0

A

D1

D1

S1

S1

B

C

Normal growthof aggregate supply

Effect of favorablesupply shock

Can have growth with stable prices.

Applying the Model

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

supply side, higher inflation rates associated with lower rates of economic growth

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A Role For Stabilization Policy

• Shifts in aggregate demand and supply causes fluctuations in real GDP and the price level

• Although the economy has a self-correcting mechanism it works slowly

• Can Government stabilization policy improve the workings of free market?• The topic of the next few chapters

48

Bringing in the Supply Side: Unemployment and Inflation? 10.

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