Chapter 27

1. Chapter 27 Bringing in the Supply Side: 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

2. The Aggregate Supply Curve • Aggregate supply curve • Each possible price level • Quantity of goods & services • All nation’s businesses - willing to produce • Specified period of time • All other determinants – constant • Aggregate supply curve • Slopes upward

3. Figure 1 An aggregate supply curve S Price Level S Real GDP

4. The Aggregate Supply Curve • Unit profit = Price – Unit cost • Aggregate supply curve - slopes upward • Firms – purchase inputs • Prices – fixed for some period of time • Higher selling prices – output • Production – more attractive • Aggregate supply curve • Shifts outward/right • More output produced • Any given price level

5. The Aggregate Supply Curve • Aggregate supply curve • Nominal wage rate – increase • Higher real production costs • Aggregate supply curve – shifts inward/left • Prices of other inputs – increase • Higher real production costs • Aggregate supply curve – shifts inward/left

6. Figure 2 A shift of the aggregate supply curve B S0 (lower wages) A 100 S1 (higher wages) Price Level (P) S0 S1 0 5,500 6,000 Real GDP (Y)

7. The Aggregate Supply Curve • Aggregate supply curve • Technology & productivity – improve • Decrease business costs • Aggregate supply curve – shift outward/right • Available supply of labor & capital – better • Labor force - grows or improves in quality • Capital stock – increases (investment) • Aggregate supply curve – shifts outward/right

8. Equilibrium: Aggregate Demand & Supply • Equilibrium GDP • Aggregate demand curve intersects • Aggregate supply curve • Equilibrium price level • Aggregate quantity demanded equals • Aggregate quantity supplied

9. Figure 3 Equilibrium of real GDP and the price level S D 130 E 120 110 Price Level (P) 100 90 80 D S 0 5,200 5,600 6,000 6,400 6,800 Real GDP (Y)

10. Equilibrium: Aggregate Demand & Supply • For price level > Equilibrium price level • Aggregate quantity supplied exceeds • Aggregate quantity demanded • Inventories – increase • Prices – forced down • Price level – falls • Production – falls

11. Equilibrium: Aggregate Demand & Supply • For price level < Equilibrium price level • Aggregate quantity demanded exceeds • Aggregate quantity supplied • Shortage of goods • Inventories – decrease • Prices – increase • Price level – rise • Production – rise

12. Table 1 Determination of the equilibrium price level

13. Inflation and the Multiplier • Actual numerical value of multiplier • Smaller – oversimplified multiplier formula • Aggregate supply curve – slopes upward • Any increase in aggregate demand • Price level – increase • Erodes purchasing power of consumer wealth • Reduces net exports • Inflation – reduces value of multiplier

14. Figure 4 Inflation and the multiplier S D1 D0 130 E1 A E0 120 110 Price Level (P) 100 $800 billion 90 80 D0 D1 S 0 6,000 6,400 6,800 Real GDP (Y)

15. Recessionary & Inflationary Gaps • Recessionary gap • Equilibrium GDP < Potential GDP • Aggregate demand – weak • Inflationary gap • Equilibrium GDP > Potential GDP • Excess aggregate demand

16. Figure 5 (a) Recessionary and inflationary gaps revisited E E B B Potential GDP 45° S C+I0+G+(X-IM) Recessionary gap Potential GDP Recessionary gap Real Expenditure Price Level D0 D0 S Real GDP Real GDP 0 7,000 7,000 6,000 6,000

17. Figure 5 (b) Recessionary and inflationary gaps revisited E E Potential GDP 45° S C+I1+G+(X-IM) Potential GDP Real Expenditure Price Level D1 D1 S Real GDP Real GDP 0 7,000 7,000

18. Figure 5 (c) Recessionary and inflationary gaps revisited Inflationary gap E B B Inflationary gap C+I2+G+(X-IM) Potential GDP E 45° S Potential GDP Real Expenditure Price Level D2 D2 S Real GDP Real GDP 0 7,000 7,000 8,000 8,000

19. Adjusting to a Recessionary Gap • Deflation or Unemployment? • Recessionary gap • Equilibrium GDP < Potential GDP • Cyclical unemployment • Wages – may fall • Aggregate supply – shift outward/right • Increase GDP to Potential GDP • Prices decline

20. Figure 6 The elimination of a recessionary gap Potential GDP S1 S0 E B F D Recessionary gap Price Level (P) 100 D S0 S1 6,000 5,000 Real GDP (Y)

21. Adjusting to a Recessionary Gap • Wages & prices – rarely fall • Institutional factors • Psychological resistance to wage reduction • Business cycles – less severe • Firms – don’t want to lose best employees • Economy - get stuck • Recessionary gap - long period

22. Adjusting to a Recessionary Gap • Self-correcting mechanism • Workers – need jobs • Willing to cut wages • Firms – willing to cut prices • Economy’s self-correcting mechanism • Money wages – react • Recessionary or Inflationary gap • Shift - aggregate supply curve • Change: • Equilibrium GDP & Equilibrium price level

23. Adjusting to Inflationary Gap: Inflation • Inflationary gap • Equilibrium GDP > Potential GDP • Tight labor market; Jobs – plentiful • Rising wages • Increase business costs • Prices increase • Aggregate supply curve – shifts inward/left • Decrease GDP to Potential GDP • Higher price level

24. Figure 7 The elimination of an inflationary gap Potential GDP S0 S1 F E B D Inflationary gap Price Level (P) D S0 S1 Real GDP (Y)

25. Adjusting to Inflationary Gap: Inflation • Self-correcting mechanism • Takes time • Stagflation • Inflation and economic stagnation • Normal – after excessive aggregate demand

26. Stagflation from a Supply Shock • Higher energy prices • Aggregate supply – shift inward • “Oil shocks” • Adverse supply shocks • Inward shift of aggregate supply • Falling production • Rising prices

27. Figure 8 Stagflation from an adverse shift in aggregate supply S0 S1 A E 36.0 D 31.8 Price Level (2000=100) D S0 S1 4,342 4,275 Real GDP

28. Applying Model to a Growing Economy • Simple model • Aggregate demand • Aggregate supply • Equilibrium price level • Equilibrium level of real GDP • U.S. : price level & real GDP, 1972-2007 • Higher price level • Higher GDP • Growth & Inflation

29. Figure 9 The price level & real GDP output in U.S., 1972–2007

30. Applying Model to a Growing Economy • Every year • Aggregate demand – grows • Shift right • Growing population • More demand: consumer & investment goods • Increased government purchases • Aggregate supply – shift right • More workers • Investment & technology • Improve productivity

31. Figure 10 S0 S1 Aggregate supply & demand analysis: growing economy A B 116.5 Price Level (P) (2000=100) 113 D1 D0 D0 D1 S1 S0 11,000 11,330 Real GDP (Y) in Billions of 2000 Dollars

32. Applying Model to a Growing Economy • Demand-side fluctuations • For Aggregate supply – grows, and • If: Aggregate demand – grows faster • Faster growth • More inflation • If: Aggregate demand – grows slower • Slower growth • Less inflation

33. S0 Figure 11 S1 The effects of faster growth of aggregate demand A C 120 Price Level (P) (2000=100) 113 D2 D0 D2 D0 S1 S0 11,000 11,500 Real GDP (Y) in Billions of 2000 Dollars

34. Figure 12 S0 S1 The effects of slower growth of aggregate demand A E 115 Price Level (P) (2000=100) 113 D3 D0 D0 D3 S1 S0 11,000 11,165 Real GDP (Y) in Billions of 2000 Dollars

35. Applying Model to a Growing Economy • Supply-side fluctuations • For Aggregate demand – grows, and • If: Aggregate supply – shifts inward • Real output – decline slightly • Prices – rapid increase • If: Aggregate supply – grows faster • Favorable supply shock • Faster economic growth • Lower inflation

36. Figure 13 Stagflation from an adverse supply shock S0 S1 B E 39.0 D0 D1 31.8 Price Level (2000=100) D1 D0 S0 S1 4,342 4,311 Real GDP (Y) in Billions of 2000 Dollars

37. Figure 14 S0 The effects of a favorable supply shock S1 Normal growth of aggregate supply Effect of favorable supply shock C A B D0 D1 Price Level (P) D0 D1 S1 S0 Real GDP (Y)

38. A Role For Stabilization Policy • Economy’s self-correcting mechanism • Works slowly • Government stabilization policy • Improve workings of free market