Aggregate Supply in the Long-Run

  1. Equilibrium adjustments in the long run
  2. demand-pull inflation→ increased output→ higher price level→ higher nominal wages → therefore, a shift of aggregate supply to the left (to full employment)
  3. cost-push inflation → leftward shift in AS caused by cost changes→ Price level increases → dilemma
  • choice 1: fiscal or monetary policy to increase AD, but also further increase price level (cost-spiral inflation, one thing leads to another, etc.).
  • Choice 2: Ignore the shift (laissez-faire) and allow the recession to occur (high unemployment, business failures) and to reduce nominal wages and demand for inputs, shifting supply back to the right.
  • Recession due to decrease in aggregate demand → decrease in output→ decrease in price level → decrease in wages → rightward shift in AS and back to full output at lower price level (big assumption that probably would only occur after long-lasting recession)

The Phillips Curve

The unemployment-Inflation Relationship

Inflation

Rate (%)

Unemployment Rate (%)

  1. Key Elements
  2. As unemployment increases, the inflation rate decreases
  3. As unemployment decreases, the inflation rate increases
  4. On surface (figure 16.7, pg 298, suggests that full employment demands a significant inflation level)
  5. There is reason to believe this is true in the short-run. However, dependable forecasts from the Phillips curve are unpredictable.

Example: 1990’s and the significant productivity gains that caused rapid increase in AS to offset inflation.

  1. Aggregate Supply Shocks (figure 16.8, pg. 299)
  2. Stagflation (stagnation and inflation)- high unemployment, high inflation

This occurred in the 1970’s and early 1980’s- would indicate an outward shift of the Phillips Curve

  1. The cause- Sudden increase in resource costs- 1970’s oil prices-caused significant shifts in the AS to the left
  2. Stagflation declined in the 1980’s due to tight money supply, causing a serious recession and increasing unemployment to 9.5 % in 1982. Wages did drop in some cases, eventually causing the AS to shift right again. See the Misery index, pg. 300.
  1. Short-run Phillips Curve- based on the supposition that when the inflation rate is higher than expected (increasing AD), firms receive higher profits temporarily and hire more workers (Figure 16.9, pg. 301)
  2. Long-Run Phillips Curve-vertical- in response to the increase in AD and profits, wage levels increase and unemployment returns to previous levels, but at the higher inflation rate- this continues as long as AD is increasing. The stable unemployment-inflation relationship does not exist in the long-run.
  3. Disinflation-the reverse of above because of declines in AD

Shifts in Aggregate Supply:Taxation

  1. “Supply-Side” economists believe that changes in AS can be a powerful fiscal tool
  2. High marginal tax rates impede productivity and investment by workers
  3. Lower tax rates encourage this productivity, shifting AS
  4. Lower tax rates encourage saving and investing, shifting AS
  5. Laffer curve

100

Tax

Rate

0 Tax Revenue

  1. Claims that reasonable tax rates maximize revenue by encouraging work, reducing tax avoidance and tax evasion
  2. Criticisms-lower tax rates allow some people to “buy more leisure”-counterproductive to the claims
  3. Increases in AD creates higher interest rates and lower investment-counterproductive to the claims
  4. Where are we on the curve? Although logical, the determination of where we are will affect the validity of the claim.
  5. The debate lingers.