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Long-Run Aggregate Supply and Aggregate Demand

Long-Run Aggregate Supply and Aggregate Demand. Chapter 11. Outline. From Short Run to Long Run Long Run Equilibrium in the AD-AS Model Economic Growth and On-Going Inflation The Inflation-Unemployment Relationship Taxation and AS. From Short Run to Long Run. Short Run (SR).

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Long-Run Aggregate Supply and Aggregate Demand

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  1. Long-Run Aggregate Supply andAggregate Demand Chapter 11

  2. Outline • From Short Run to Long Run • Long Run Equilibrium in the AD-AS Model • Economic Growth and On-Going Inflation • The Inflation-Unemployment Relationship • Taxation and AS

  3. From Short Run to Long Run Short Run (SR) Long Run (LR) A period in which output prices are flexible, output prices, but wages and other input prices wages, and other input prices are inflexible. are all flexible. The SRAS is upward-sloping. The LRAS is vertical at Qf. ASLR P P AS1 AS1 P2 P2 a1 P1 P1 a1 P3 P3 Q($bil) Q($bil) 8/21/2014 3 Qf Qf

  4. From Short Run to Long Run In the LR, output prices, wages and input prices are all flexible. If the price level falls from P1 to P3, firms decrease output in the SR. The economy moves down along AS1.Wages and input prices also decrease, shifting AS1 to the right to AS3. The economy moves to point c1 on LRAS and AS3.The nation’s unemployment rate falls to its natural rate.Again, the LRAS is vertical at Qf. In the LR, output prices, wages and input prices are all flexible. If the price level rises from P1 to P2, firms increase output in the SR. The economy moves up along AS1.Wages and input prices also increase, shifting AS1 to the left to AS2. The economy moves to point b1 on LRAS and AS2.The nation’s unemployment rate rises to its natural rate.The LRAS is vertical at Qf. Three assumptions about SRAS AS1: (1) The initial price level is P1; (2) this price level is expected to persist; (3) the price level can be flexible both upward and downward Vice versa. if the price level falls from P1 to P3. In the SR, firms make lessprofits because lower prices decrease their revenues while they incur the same input costs. Firms decrease output to Q3. The economy moves down to point a3 on AS1.The nation’s unemployment rate rises above its natural rate. Now suppose that the price level rises to P2. In the SR, nominal wages and input prices remain unchanged.Firms incur the same costs. Higher output prices increase their revenuesand thus their profits. Firms increase output to Q2. The economy moves up to point a2 on AS1, which slopes upward. The nation’s unemployment rate declines below its natural rate. At a1, the economy operates at full employment, potential output Qf. The price level is P1. The unemployment rate is un, the natural rate of unemployment. AS2 ASLR P P AS1 AS1 a2 b1 a2 AS3 P2 P2 a1 P1 P1 a1 a3 P3 P3 c1 a3 Q($bil) Q($bil) 8/21/2014 Q3 Qf Q2 4 Qf

  5. LR Equilibrium in the AD-AS Model • Demand-pull inflation in the LR AD-AS model • Cost-push inflation in the LR AD-AS model • Recession in the LR AD-AS model

  6. LR Equilibrium in the AD-AS Model The LR AD-AS model is a model in which the equilibrium price level and the level of real GDP are determined by the intersection of the AD curve and the LRAS curve. 8/21/2014 6

  7. LR Equilibrium in the AD-AS Model LR equilibrium occurs where three curves, LRAS, SRAS, and AD, intersect.The economy achieves its LR equilibrium at E1 and produces full-employment output Qf. LRAS AS1 Price LevelP (index) E1 P1 AD1 Real GDP($billion) 8/21/2014 Qf 7

  8. Demand-pull inflation in LR AD-AS model In the SR, an increase in AD from AD1 to AD2 causes demand-pull inflation. The price level and real GDP both rise.The economy moves from E1 to E2. In the LR, wages and input prices also rise, causing the SRAS curve to shift leftward, from AS1 to AS2. Real GDP falls back to its prior level Qf, and the price level rises to P3. The economy moves from E2 to E3. LRAS AS1 AS2 Price LevelP (index) E3 P3 E2 P2 E1 AD2 P1 AD1 Real GDP($billion) 8/21/2014 Qf 8 Q2

  9. Cost-push inflation in LR AD-AS model In the SR, a decrease in AS from AS1 to AS2 causes cost-push inflation. The price level rises and real GDP falls.The economy moves from E1 to E2. If the government does nothing, in the LR, the reduction in real GDP lowers the demand for inputs. Wages and input prices fall, causing AS to shift back to AS2. The economy moves from E1 to E2 then eventually back to E1. However, if the government counters the decline in real GDP by increasing AD from AD1 to AD2, the price level will rise to P3.The economy moves from E1 to E2 then to E3. LRAS AS1 AS2 Price LevelP (index) E3 P3 P2 E2 E1 AD2 P1 AD1 Real GDP($billion) 8/21/2014 Qf 9 Q2

  10. Recession in LR AD-AS model In the SR, a decrease in AD from AD1 to AD2 causes a recession. Both the price level and real GDP fall.The economy moves from E1 to E2. If the government does nothing, in the LR, the reduction in real GDP lowers the demand for inputs. Wages and input prices fall, causing AS to shift to AS2. The economy moves from E1 to E2 then eventually to E3. LRAS AS2 AS1 Price LevelP (index) E1 P1 P2 E2 E3 AD1 P3 AD2 Real GDP($billion) 8/21/2014 Qf 10 Q2

  11. Summary Short Run Long Run Situation Cause Outcomes Outcomes (Laissez-faire non-intervention policy) Demand-pullinflation AD up Q up (U down)P up AS down Q down (U up)P up (more inflation) Cost-pushinflation AS down Q down (U up)P up AS up Q up (U down)P down Recession AD down Q down (U up)P down AS up Q up (U down)P down (more deflation)

  12. Summary Short Run Long Run Situation Cause Outcomes OutcomesGovernment intervention Demand-pullinflation AD up Q up (U down)P up AD down Q down (U up)P down Cost-pushinflation AS down Q down (U up)P up AD up Q up (U down)P up (more inflation) AD down Q down (U up/higher)P down Recession AD down Q down (U up)P down AD up Q up (U down)P up 8/21/2014 12

  13. Production possibilities and LRAS In the LR, supply factors (advances in technology and more and better resources) cause the economy to grow. The PPC shifts to the right to CD.The economy’s LRAS also shifts to the right to LRAS2, where Q2 is the new real GDP. Originally, the economy’s PPC is AB. The LR aggregate supply is LRAS1, the full-employment real GDP is Q1. Capital goods Price level LRAS1 LRAS2 C A D 8/21/2014 Q1 13 Q2 B Consumer goods Real GDP

  14. Economic Growth and On-Going Inflation Over long periods, any inflation that occurs is the result of the growth of AD. Originally, the economy achieved LR equilibrium at E1, where LRAS1, AS1, and AD1 cross. The price level is P1 and the full-employment real GDP Q1. Over time, supply factors shift both LRAS and AS to the right. Simultaneously, increases in population and money supply also shifts AD to the right. The economy grows but experiences higher prices or on-going inflation. LRAS1 LRAS2 AS2 Price level P AS1 E2 P2 AD2 E1 P1 AD1 Real GDP Q 8/21/2014 Q1 Q2 14

  15. The Inflation-Unemployment Relationship • SR trade-off: the Phillips curve • AS shocks and shifts of the Phillips curve • No LR inflation-unemployment trade-off

  16. Three important points Under normal circumstances, a SR trade-off exists between the rate of inflation, p (%), and the rate of unemployment, u (%). AS shocks can cause both higher rates of inflation and higher rates of unemployment. No significant trade-off exists between inflation and unemployment over long periods of time. 8/21/2014 16

  17. SR trade-off: the Phillips curve (PC) The SR Phillips curve is derived as a result of shifts in AD. In the SR, an increase in AD shifts the AD curve to the right to AD2, causing the pricelevel to rise to P2, i.e. higher inflation, and real GDP to rise to Q2, i.e. lower unemployment. The economy moves from a to b on both diagrams. The SR Phillips curve PC1 is drawn by connecting three points a, b, and c. It shows a trade-off between the inflation rate, p(%), and the unemployment rate, u(%).When one rate is higher, the other rate is lower, and vice versa. In the SR, a decrease in AD shifts the AD curve to the left to AD3, causing the pricelevel to fall to P3, i.e. lower inflation, and real GDP to fall to Q3, i.e. higher unemployment. The economy moves from a to c on both diagrams. Originally, the economy achieves equilibrium at a. The price level is P1 and real GDP Q1,as shown on the left diagram below.At a, the corresponding inflation rate is p1 and unemployment rate u1,as shown on the right diagram. P p (%) AD2 AS1 PC1 AD1 b AD3 b P2 p2 a a c P1 p1 c P3 p3 8/21/2014 u2 17 u1 u3 Q3 Q1 Q2 Q u (%)

  18. AS shocks and shifts of the Phillips curve In the SR, an increase in AS shifts the AS curve to the right to AS2, causing the pricelevel to fall to P2, i.e. lower inflation, and real GDP to rise to Q2, i.e. lower unemployment. The economy moves from a to b on both diagrams. The SR Phillips curve shifts in opposite directions with a shift in SRAS. Originally, the economy achieves equilibrium at a. The price level is P1 and real GDP Q1,as shown on the left diagram below.At a, the corresponding inflation rate is p1 and unemployment rate u1,as shown on the right diagram. Point a is on PC1. Since three points a, b, and c, cannot be on the same SR Phillips curve, it means that the Phillips curve shifts.Shifts/changes in AS cause both inflation and unemployment rates to change inthe opposite direction. In the SR, a decrease in AS shifts the AS curve to the left to AS3, causing the pricelevel to rise to P3, i.e. higher inflation, and real GDP to fall to Q3, i.e. higher unemployment. The economy moves from a to c on both diagrams. P p (%) AS3 AS1 AS2 PC1 PC3 PC2 AD1 c c p3 P3 a b P1 p1 a b P2 p2 8/21/2014 u2 18 u1 u3 Q3 Q1 Q2 Q u (%)

  19. No LR inflation-unemployment trade-off The LR Phillips curve is vertical at the natural rate of unemployment, un, which corresponds to the full-employment, potential output Qf,from where the LRAS starts. In the LR, AD increases to AD2, causing the economy to move from point a to a’ onthe right diagram. LR self-adjustment brings the economy to point b on both diagrams, back to Qf and un again. The process continues. Originally, the economy is at a on both diagrams. The LR aggregate supply is LRAS, the AD is AD1 and the SR PC is PC1.The economy achieves full-employment real GDP Qf, at the natural rate of unemployment un. P p(%) LRAS LRPC c c P3 b’ AD3 b P2 b PC3 a’ AD2 a a P1 PC2 AD1 PC1 8/21/2014 Qf un 19 Q u(%)

  20. Taxation and AS • The Laffer curve • Criticisms, rebuttal, and assessment

  21. Supply-side economics A view of macroeconomics that emphasizes the role of marginal tax rates and other factors that affect LRAS and therefore affect inflation, unemployment, and economic growth. Marginal tax rates, the rates on extra dollars of income, vary from 10% to 35% in the U.S. 8/21/2014 21

  22. Taxation and AS High marginal tax rates reduce people’s incentives to work, save, or invest more. To expand LRAS and economic growth, government should lower marginal tax rates. Changing marginal tax rates affect government tax revenue. 8/21/2014 22

  23. The Laffer curve Marginal tax rates negatively affect productivity, output, and tax revenue. Tax rate(%) Laffer curve High tax rates reduce productivity, output,and thus tax revenue m Low tax rates increase productivity, output,and thus tax revenue Maximum taxrevenue 8/21/2014 23 Tax revenue ($)

  24. Criticisms, rebuttals, and assessment Skeptics say there is ample empirical evidence showing that the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge. The issue of where a particular economy is located on its Laffer curve is an empirical question. 8/21/2014 24

  25. Criticisms, rebuttals, and assessment Supply-side advocates contend that the Reagan tax cuts in the 1980s worked as Laffer predicted. The tax-rate cuts did not, however, produce extraordinary rightward shifts of the LRAS.. 8/21/2014 25

  26. Criticisms, rebuttals, and assessment There is general agreement that the U.S. economy is operating at a point below m on the Laffer curve. Supply-side economics has contributed to how economists and policymakers design and implement fiscal policy. 8/21/2014 26

  27. See You! Take Care! 8/21/2014 27

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