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26Supply-Side Equilibrium: 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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Copyright 2003 Southwestern/Thomson Learning All rights reserved.

ContentsThe Aggregate Supply CurveEquilibrium of Aggregate Demand and SupplyRecessionary and Inflationary Gaps RevisitedAdjusting to a Recessionary Gap: Deflation or Unemployment?Copyright 2003 South-Western/Thomson Learning. All rights reserved.

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Contents (continued)Adjusting to an Inflationary Gap: InflationStagflation from a Supply ShockInflation and the MultiplierA Role for Stabilization PolicyCopyright 2003 South-Western/Thomson Learning. All rights reserved.

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The Aggregate Supply CurveThe aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied, holding all other determinants of quantity supplied constant.

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FIGURE 26-1 An Aggregate Supply CurveCopyright 2003 South-Western/Thomson Learning. All rights reserved.Price Level Real GDP

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The Aggregate Supply CurveWhy the Aggregate Supply Curve Slopes UpwardFirms normally can purchase labor and other inputs at prices that are fixed for some period of time.Higher prices, thus, mean higher profits and more incentive to produce.

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The Aggregate Supply CurveShifts of the Aggregate Supply CurveCosts of production are constant along the AS curve. costs of production shifts in the AS curveThe money wage ratePrices of other inputsTechnology and productivityAvailable supplies of labor and capital

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FIGURE 26-2 A Shift of the Aggregate Supply CurveCopyright 2003 South-Western/Thomson Learning. All rights reserved.100 6,000 Price Level 5,500 Real GDP

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The Aggregate Supply CurveShifts of the Aggregate Supply Curve cost of production inward shift of AS curveMoney wage rateInterest rateMaterials prices

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The Aggregate Supply CurveShifts of the Aggregate Supply Curve costs of production outward shift of AS curveImprovements in technologyIncreases in productivity Increases in supplies of labor and capital

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Equilibrium of Aggregate Demand and SupplyPrice level adjustments AS-AD equilibriumImbalance between AS and AD inventories price quantity of AS and AD

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FIGURE 26-3 Equilibrium of Real GDP and the Price LevelCopyright 2003 South-Western/Thomson Learning. All rights reserved.Price Level 90 130 110 80 120 100 6,400 6,800 5,200 5,600 6,000 Real GDP

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TABLE 26-1 Determination of the Equilibrium Price LevelCopyright 2003 South-Western/Thomson Learning. All rights reserved.

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Recessionary and Inflationary Gaps RevisitedShort run: AS-AD equilibrium may or may not equal full employment GDPRecessionary gap: Equilibrium GDP < Potential GDPInflationary gap: Equilibrium GDP > Potential GDP

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Recessionary and Inflationary Gaps RevisitedLong-run: market forces make equilibrium GDP = potential GDP

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FIGURE 26-5 The Elimination of a Recessionary GapCopyright 2003 South-Western/Thomson Learning. All rights reserved.100 5,000 Price Level 6,000 Real GDP

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Adjusting to a Recessionary GapWhen unemployment exists, if money wages fall: The aggregate supply curve will shift outwardFull employment will be attained eventually

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Adjusting to a Recessionary GapIn the real economy, however, wage reductions are slow and uncertain, particularly in the post-World War II period.

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Adjusting to a Recessionary GapThere are several possible reasons why wages are so sticky in the downward direction:Institutional rigiditiesPsychological resistanceReduced severity of business cycles Competition for the best workers

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Adjusting to a Recessionary GapWith sticky wages, cyclical unemployment may last a long time.

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Adjusting to a Recessionary GapDoes the Economy Have a Self-Correcting Mechanism?The economy will self-adjust eventually. wages demand for labor prices demand for goods and servicesBut many people believe that government intervention should help to speed the process.

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Adjusting to a Recessionary GapAn Example from Recent History: Disinflation in Japan the 1990sRecovery from the 1990-1991 recession was weak and long delayed, but it did eventually come.Practical question: How long can we afford to wait?

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Adjusting to an Inflationary GapWhen GDP > full employmentPrice level risesLabor is in short supplyBoth forces money wagesAS curve shifts inwardEmployment fallsEventually eliminates the inflationary gap

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FIGURE 26-6 The Elimination of an Inflationary GapCopyright 2003 South-Western/Thomson Learning. All rights reserved.Real GDP Price Level

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Adjusting to an Inflationary GapDuring this process, both prices and unemployment are increasing.Stagflation = inflation that occurs while the economy is growing slowly or having a recession

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Adjusting to an Inflationary GapDemand Inflation and StagflationIn an inflationary gap, prices and wages rise because of excess demand.Rising wages are a symptom, not a cause, of the underlying problem.A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand.

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Adjusting to an Inflationary GapThe stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP.

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Adjusting to an Inflationary GapThe U.S. economy has experienced two episodes of stagflation in the last decade.The more notable one came between 1988 and 1990 low unemployment was accompanied by moderate inflation.A milder version of this same phenomenon occurred in the first half of 1999; however, inflation was generally held in check.

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Stagflation from a Supply ShockIndependent shifts inward in aggregate supply are a second cause of stagflation.The increase in world oil prices caused such a shift twice in the 1970s.Favorable supply shocks tend to push output up and reduce inflation.

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FIGURE 26-7 Stagflation from an Advance Shift in ASCopyright 2003 South-Western/Thomson Learning. All rights reserved.40.0 33.6 4,099 Price Level (1996 = 100) 4,123 Real GDP

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Inflation and the MultiplierInflation size of the multiplierAs long as the aggregate supply curve is upward sloping, AD price levelThis, in turn, drains off some of the higher real demand. purchasing power of consumer wealth net exports

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FIGURE 26-8 Inflation and the MultiplierCopyright 2003 South-Western/Thomson Learning. All rights reserved.6,000 120 100 6,600 Price Level 6,800 Real GDP

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A Role for Stabilization PolicySince the economys self-correcting mechanism sometimes works slowly, there is room for government stabilization policy to improve the workings of the free market.

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