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Extending Aggregate Supply

Extending Aggregate Supply. Previous Assumption. Shift in AD  no effect AS Actuality “long-term”: AD up price level up lower real wages negotiate higher nominal wages to restore real wage left shift in AS Real wage: Nominal/price index (as decimal) $10/1.0= $10 $10/2.0=$5

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Extending Aggregate Supply

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  1. Extending Aggregate Supply

  2. Previous Assumption • Shift in AD no effect AS • Actuality “long-term”: AD up price level up lower real wages negotiate higher nominal wages to restore real wage left shift in AS • Real wage: Nominal/price index (as decimal) • $10/1.0= $10 $10/2.0=$5 • Review Determinants of AS: • 1) Input prices (domestic resources, imported resources, market power) • 2) Productivity • 3) Legal-institutional environment (taxes, regulations)

  3. Short-Run / Long-Run • Short-run: “a period in which nominal input prices remain fixed as the price level changes” • 1) Resource providers may be unaware of extent of price change no adjustment of supply/demand • 2) Contracts • Long-run: “a period in which nominal wages are fully responsive to changes in the price level”

  4. Short-Run AS • 1) Initial price level is P1; 2) nominal wages set on expectation this price level will persist; 3) price level flexible up and down • a1 at price level P1 is Qf, natural rate unemployment

  5. AS a2 PL2 a1 PL1 a3 PL3 Q3 Qf Q2

  6. P2: increased revenues, fixed wages higher profits increase output (above Qf, below natural rate U) • P1: reduced revenues reduced profits lay-offs reduce output (below Qf, above natural rate U)

  7. Long-Run AS • P2 initially increases output, but demands for higher nominal wages (now expect P2 will continue) fall back to Qf • P3 initially decreases output, but bosses negotiate lower nominal wages (now expect P3) rise back to Qf

  8. ASLR ASsr a2 b1 PL2 a1 PL1 a3 c1 PL3 Q3 Qf Q2

  9. Equilibrium in Extended AS-AD ASsr ASlr PL a AD Qf

  10. Short-run AS positive slope: nominal wages constant • Long-run AS vertical: nominal wages adjusted • Equil GDP + price level: intersection AD, ASlr and ASsr

  11. Applying Extended AS-AD Model • 1. Demand-pull inflation (AD up PL up) ASsr ASlr PL2 PL a AD2 AD1 Qf

  12. ASsr2 ASlr ASsr1 c P2 b P a AD1 Qf Q2 p334

  13. Short-run: d-p i P and real output up • Long-run: movement along ASlr • Economy can only exceed Qf for short time before renegotiating prices back to Qf

  14. 2) Cost-Push Inflation ASsr2 ASsr1 ASlr b P2 P a Shift is cause of price change (in d-p I is result) AD Q2 Qf

  15. Policy Dilemma • W/o expansionary policy AD doesn’t shift output decline (recession) • BUT, expansion further inflation • AND, negotiate higher nominal wages left shift AS higher inflation, and so on • Do nothing? Recession lower demand resources falling prices undo initial AS shift

  16. Generalizations • 1) Attempt to maintain full employment in cost-push inflationary spiral • 2) Hands-off recession that eventually corrects (at cost of higher unemployment and loss of real output)

  17. 3) Recession • Most controversial • Suppose investment spending dramatically declines AD shifts left • IF prices downwardly flexible, PL falls higher real wages AS shifts left lower nominal wages AS shifts right equilibrium at lower price level • No need for fiscal or monetary policy

  18. ASsr1 ASlr ASsr2 P a b P2 AD1 P3 AD2 p335 Q2 Qf c

  19. Disagreement: if adjustments forthcoming, only after extended period of recession/depression

  20. The Phillips Curve • Suppose right shift in AD increase in P and Q decrease unemployment • Greater shift in AD even greater P, Q, and U changes • Smaller shift in AD smaller changes • Generalization: Assuming constant ASsr, high inflation accompanied by low U; low I accompanied by high U

  21. Annual rate of inflation (%) Unemployment rate (%)

  22. Tradeoffs • Tradeoff I and U “full employment without inflation” is impossible • Question is: where along Philips Curve do we want to be? • Expansionary: low U + high I • Contractionary: high U + low I • Fiscal/monetary policy moves economy along the curve in the short-run

  23. Annual rate of inflation (%) 12 2 2 Unemployment rate (%) 9

  24. Stagflation • Stable PC in 1960s highly unstable 1970s + 1980s • Inverse relationship became obscure and questionable • 1970s: high I + high U (stagflation) • At best: PC shifted higher levels of U and higher levels of I • At worst: no dependable relationship

  25. Annual rate of inflation (%) 12 2 2 Unemployment rate (%) 9

  26. Cause Stagflation? • Aggregate Supply Shock: rapid, significant increase resource costs leftward jolt AS • Cost-push Inflation undermines assumption of PC (stable AS)

  27. Stagflation’s Demise • 1) deep recession ‘81-82: v. tight monetary policy (Paul Volcker) high U smaller increase nominal wages (bad job>no job) + firms kept prices down (hold onto diminished market share) • 2) Foreign competition • 3) Deregulation (Reagan) • 4) Decline OPEC monopoly power •  right shift AS return to PC of 1960s

  28. Natural-Rate Hypothesis • Explanation 1 of stagflation: PC still holds true, 70s+80s just abnormal • Explanation 2: no inverse relationship; economy is stable at natural rate (full employment) • U above or below NRΔ inflation • NAIRU

  29. Adaptive Expectations Theory • Assumption: expectations about future inflation based on current inflation • Short-run tradeoff I and U, but not in long-run • Attempts to lower U below NR instability right shift in PC

  30. Short-run PC: expected inflation ≠ actual inflation

  31. PClr b1 6 a1 3 PCsr 4 6=NR

  32. Movement consistent w/ AS-AD and original PC assumptions greater output at cost of higher inflation • Perhaps because expansionary policy because G misjudged natural rate • Adaptive Expectations: “When the actual rate of inflation is higher than expected, profits temporarily rise and unemployment rate temporarily falls.”

  33. PClr Point B not stable b1 6 a1 3 PCsr 4 6

  34. Nominal wages not increased as fast as inflation negotiate higher wages profits fall employment + output falls back to full employment at higher PL

  35. PClr b1 6 a2 3 a1 PCsr2 PCsr1 4 6

  36. Higher actual and expected inflation (6%) PCsr shifts • Movement along PCsr1 (a1 b1) long-run shift back to natural rate • G policy may continue upward movement of prices (if again misjudge causes)

  37. G attempts to move along PC causes shift to less favorable position long-run Philips Curve showing levels of inflation at full-employment U • So society should choose low inflation over high

  38. PClr b1 6 a2 3 a1 PCsr2 PCsr1 4 6

  39. Disinflation • When the actual rate of inflation is lower than the expected rate, profits temporarily fall and the unemployment rate temporarily rises. • Fall in inflation fall in profits higher U negotiate down nominal wages U falls • PC shifts left, new equilibrium back at long-run PC

  40. PClr a3 b1 c3 6 a2 PCsr1 3 a1 PCsr2 4 6

  41. Rational Expectations Theory • Adaptive Expectations assumes people respond to changes, RE assumes f + h anticipate impacts of G and factor into their decision making • Result: if G policy fully anticipated no increase profit/output/employment but quick increase inflation • Both support conservative view that G policy typically fails

  42. Shifts in Philips Curve • Expectations: in long-run expected inflation adjusts to changes actual inflation new level of I at NRU • Supply shocks

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