Chapter 10 Bringing in the Supply Side: Unemployment and Inflation? We might as well reasonably...

Chapter 10

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

Why AS?

• Chapter 9 tells us change in AD will create inflationary gap vs. recessionary gap

• Which sort of gap will arise?• Need to know priceprice level• AS + AD determine price level• This chapter: bring the supplysupply side back

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 upwardupward

3

An aggregate supply curve

Figure 1

4

Real GDP

Pric

e Le

vel

S

S

The AS Curve: Why Upward Slope?

• 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


• Aggregate supply curve– Nominal wage rateNominal wage rate – increase

• Higher real production costs• Aggregate supply curve – shifts inward/left

– Prices of other inputsPrices of other inputs – increase • Higher real production costs• Aggregate supply curve – shifts inward/left

6

A shift of the aggregate supply curve

Figure 2

7

0

Real GDP (Y)

Pric

e Le

vel (

P)

6,0005,500

S0 (lower wages)

S0

S1 (higher wages)

S1

100A

B


• Aggregate supply curve– Technology & productivityTechnology & productivity – improve

• Decrease business costs• Aggregate supply curve – shift outward/right

– Available supply of labor & capitalAvailable 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– AD curve intersects AS curve

– Equilibrium price level

– Equilibrium quantity

9

Equilibrium of real GDP and the price level

Figure 3

10

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


• For price level > Equilibrium price level– Aggregate quantity supplied exceeds

• Aggregate quantity demanded

– Inventories – increase• Prices – forced down

– Price level – falls

– Production – falls

11


• 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

Determination of the equilibrium price level

Table 1

13

(1) (2) (3) (4) (5)

PriceLevel

AggregateQuantity

Demanded

AggregateQuantitySupplied

Balance of Supplyand Demand

Prices will be:

8090

100110120

$6,4006,2006,0005,8005,600

$5,6005,8006,0006,2006,400

Demand exceeds supplyDemand exceeds supplyDemand equals supplySupply exceeds demandSupply exceeds demand

RisingRising

UnchangedFallingfalling

Inflation and the Multiplier

• 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

Inflation and the multiplier

Figure 4

15

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

$800

billion

E1

E0

Recessionary & Inflationary Gaps

• Recessionary gap– Equilibrium GDP < Potential GDP

– Aggregate demand – weak

• Inflationary gap– Equilibrium GDP > Potential GDP

– Excess aggregate demand

16

Recessionary and inflationary gaps revisited

Figure 5 (a)

17

Real GDP

Rea

l Exp

endi

ture45°

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)

18

Real GDP

Rea

l Exp

endi

ture45°

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)

19

Real GDP

Rea

l Exp

endi

ture45°

C+I2+G+(X-IM)

8,0007,000

Potential GDP

BE

Inflationary

gap

0 Real GDP

Pric

e Le

vel

Inflationary

gap

8,0007,000

Potential GDP

BS

S D2

D2 E

Adjusting to a Recessionary Gap

• Recessionary gap

cyclical unemployment wage AS curve shifts outwardoutward

Y, P• It is a self-correcting mechanismself-correcting mechanism

20

The elimination of a recessionary gap

Figure 6

21Real GDP (Y)

Pric

e Le

vel (

P)

Recessionary

gap

5,000 6,000

Potential

GDP

B

S0

S0

D

DS1

S1

F

E

100

Adjusting to a Recessionary Gap

• In reality, wages & prices rarely fall– Institutional factors: minimum wage law,

union contracts

– 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 Inflationary Gap: Inflation

• Inflationary gap

over employment

wage AS shifts inwardinward

Y, P • Again, it is a self-correctingself-correcting mechanism

23

The elimination of an inflationary gap

Figure 7

24

Real GDP (Y)

Pric

e Le

vel (

P)

Inflationary

gap

Potential

GDP

B

S0

S0

D

DS1

S1

F

E

Adjusting to Inflationary Gap: Inflation

• Self-correcting mechanism– Takes time

• Stagflation– Inflation and economic stagnation

– Normal – after excessive aggregate demand

25

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

26

Stagflation from an adverse shift in aggregate supply

Figure 8

27

S0

S0

D

D

S1

S1

A

Real GDP

Pric

e Le

vel

(200

0=10

0)

4,3424,275

31.836.0 E

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 & Inflation28

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

Figure 9

29


• 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

30

Aggregate supply & demand analysis: growing economy

Figure 10

31

S0

S0 D0

D0

Real GDP (Y) in Billions of 2000 Dollars

Pric

e Le

vel (

P)

(200

0=10

0)

11,000 11,330

113

116.5

A

D1

D1

S1

S1

B


• Demand-side fluctuations– For Aggregate supply – grows, and

• If: Aggregate demand – grows faster– Faster growth– More inflation– Economic boom

• If: Aggregate demand – grows slower– Slower growth– Less inflation– Economic recession

32

The effects of faster growth of aggregate demand

Figure 11

33

S0

S0 D0

D0


Pric

e Le

vel (

P)

(200

0=10

0)

11,000 11,500

113

120

A

D2

D2

S1

S1

C

The effects of slower growth of aggregate demand

Figure 12

34

S0

S0 D0

D0


Pric

e Le

vel (

P)

(200

0=10

0)

11,000 11,165

113115 A

D3

D3

S1

S1

E


• Supply-side fluctuations– For Aggregate demand – grows, and

• If: Aggregate supply – shifts inward– Real output – decline slightly– Prices – rapid increase– Stagflation

• If: Aggregate supply – grows faster– Favorable supply shock– Faster economic growth– Lower inflation

35

Stagflation from an adverse supply shock

Figure 13

36

S0

S0

D0

D0

S1

S1


Pric

e Le

vel

(200

0=10

0)

4,3424,311

31.8

39.0

ED1

D1 B

The effects of a favorable supply shock

Figure 14

37

Real GDP (Y)

Pric

e Le

vel (

P)

S0

S0 D0

D0

A

D1

D1

S1

S1

B

C

Normal growth

of aggregate supply

Effect of favorable

supply shock

Big Picture

• Chapter 8: compositioncomposition of AD and the volatility of investment

• Chapter 9: changes in investment have multipliermultiplier effects on AD (given price)

• This chapter: show how shifts in AD curve cause fluctuations in both GDPGDP and priceprice

38

A Role For Stabilization Policy

• Economy’s self-correcting mechanism– Works slowly

• Government stabilization policy– Improve workings of free market

Summary

• AS curve: upward slope• Shifts of AS curve• Equilibrium of AS-AD• Self-Correcting Mechanism of

Economy• The process might be slow • Need government stabilization policy

Chapter 10 Bringing in the Supply Side: Unemployment and Inflation? We might as well reasonably...

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