Part VIII: Aggregate Supply Demand-Pull Inflation Cost-Push Inflation

1. ECONOMICS What does it mean to me? • Part VIII: • Aggregate Supply • Demand-Pull Inflation • Cost-Push Inflation

2. READ Krugman Ch 27, 28 Mankiw Ch Morton Unit 3

3. AGGREGATE SUPPLY A schedule or a curve showing the level of real domestic output which will be produced at each price level. Higher price levels create an incentive for enterprises to produce and sell more output, while lower price levels reduce output. One can divide the supply curve into two parts: the short-term supply curve and the long-term supply curve.

4. PRICE LEVELS The short-run relationship refers to a period when output can change in response to supply and demand, but input prices have not yet been able to adjust. Higher prices give incentive for enterprises to produce and sell more output, while lower prices reduce output. SRAS B PL1 PL0 A RGDP0 RGDP1 LRAS PRICE LEVELS Real Gross Domestic Product The long-run supply curve reflect the relationship between RGDP produced and price level, once input prices have been able to respond to changes in output prices. The vertical curve reflects the fact that producers are willing to supply is not affected by changes in price. RGDPFE Real Gross Domestic Product

5. The Short-Run Aggregate Supply Curve *Krugman

6. Another way of viewing Aggregate Supply is to divide the curve into three segments: d PRICE LEVELS Vertical range (long-run) Intermediate range (Short-run) c • Horizontal Range (ab) • Intermediate Range (bc) • Vertical Range (cd) a b Horizontal range QU QF QC Real Gross Domestic Product

7. HORIZONTAL RANGE: (ab) includes only real levels of output which are substantially less than the full-employment output (QF). This country: • is in a severe recession or depression • large amounts of unused machinery , equipment, unemployed workers . d PRICE LEVELS Vertical range (long-run) Intermediate range (Short-run) c a b Horizontal range QU QF QC Real Gross Domestic Product

8. d PRICE LEVELS Vertical range (long-run) • VERTICAL RANGE: (cd) the economy reaches its full-capacity real output at QC. This economy is: • operating at its full capacity. • *Individual firms may try to expand production by bidding resources away from other firms. • *This bidding will raise resource prices and costs and ultimately product prices, but real output will remain unchanged. This is an INFLATIONARY period. Intermediate range (Short-run) c a b Horizontal range QU QF QC Real Gross Domestic Product

9. INTERMEDIATE RANGE: (bc) between QU and QC , an expansion of real output is accompanied by a rising price level. The aggregate economy is made up of innumerable product and resource markets, and full employment is not reached evenly or simultaneously in the various sectors or industries. d PRICE LEVELS Vertical range (long-run) Intermediate range (Short-run) c a b Horizontal range QU QF QC Real Gross Domestic Product In the intermediate range of aggregate supply, per-unit production costs rise and firms must receive higher product prices for their output to be profitable. In this range, rising real output is accompanied by an increasing price level.

10. PRICE LEVELS When discussing the shape of the aggregate supply curve, it is revealed that real output increases as the economy moves from left to right through the horizontal ranges of aggregate supply. These changes result from movements ALONG the aggregate supply curve Real Gross Domestic Product and must be distinguished from shifts of the curve itself. An existing aggregate supply curve identifies the relationship between the price level and real output, other things being equal.

11. What causes the aggregate supply curves to shift? 1. Changes in input prices a) Domestic resource availability a1 Land a2 Labor a3 Capital a4 Entrepreneurial ability b) Prices of imported resources c) Market power 2. Change in Productivity 3. Change in legal-institutional environment a) Business taxes and subsidies b) Government regulations DETERMINANTS Of AGGREGATE SUPPLY

12. 1. Changes in input prices Input prices or resource prices are a major determinant of aggregate supply. Ceteris paribus, higher input prices increase per-unit production costs and reduce aggregate supply. Lower input prices do just the opposite.

13. a) Domestic resource availability a1 Land Land resources might expand through discoveries of mineral deposits, irrigation of land, or technical innovations. An increasein the supply of land resources lowers the price of land inputs, lowering per-unit costs. Two examples of reductions in land-resource availability may also be cited: 1) the widespread depletion of the nation’s underground water reserves through irrigation, 2) the nation’s loss of topsoil through intensive farming. Eventually, these problems may increase water and land prices and shift the aggregate supply curve leftward.

14. a) Domestic resource availability a2 Labor About 75 percent of all business costs are wages or salaries. An increase in the availability of labor resource reduces the price of labor and increases aggregate supply. (i.e.) Aftr World War II, the influx of women into the labor force placed a downward pressure on wages and expanded U.S. aggregate supply. (i.e.) Immigration of employable workers from abroad has historically increased the availability of labor in the U.S. and reduced wages.

15. a) Domestic resource availability a3 Capital Aggregate supply usually increases when society adds to its stock of capital. Such an addition would happen if society saved more of its income and used the savings to purchase capital goods. On the other hand, aggregate supply declines when the quantity and quality of the nation’s stock of capital diminishes. For example, during the Great Depression of the 1930s, the U.S. capital stock deteriorated because new purchases were insufficient to offset the normal wearing out and obsolescence of plant and equipment. Aggregate supply declined.

16. a) Domestic resource availability a4 Entrepreneurial ability & Technology Ceteris paribus, the amount of entrepreneurial ability available to the economy may change, shifting the aggregate supply curve. If entrepreneurial activities or technology lowers the costs of production and expands what might be produced in the economy, then the aggregate supply curves both shift to the right.

17. b) Prices of imported resources A decrease in the prices of imported resources expands a nation’s aggregate supply; an increase in the prices reduces aggregate supply. Exchange rate fluctuations are one factor that alters the price of imported resources. If the dollar price of a foreign currency falls--the dollar appreciates--this enables U.S. firms to obtain more foreign currency with their dollar. Under these conditions, U.S. firms would expand their imports of foreign resources and realize reductions in per-unit production costs at each level of output. Falling per-unit production costs of this type shift the U.S. aggregate supply curve to the right. An increase in the dollar price of foreign currency--dollar depreciation-- raises the prices of imported resources.

18. c) Market power Market power is the ability to set a price above the price that would occur in a competitive situation. The rise and fall of market power held cut the Organization of Petroleum Exporting Countries (OPEC) during the past three decades is a good illustration. The tenfold increase in the price of oil that OPEC achieved during the 1970s permeated the economy, drove up per-unit production costs, and jolted the U.S. aggregate supply curve.

19. 2. Change in Productivity Productivity relates a nation’s level of real output to the quantity of input used to produce that output. In other words, PRODUCTIVITY is a measure of average real output, or of real output per unit of input: total output total input Productivity = An increase in productivity means the economy can obtain more real out put from its limited resources--its inputs.

20. How does an increase in productivity affect the aggregate supply curve? We first need to see how a change in productivity alters the per-unit production cost. Suppose real output is 10 units, 5 units of input are needed to produce that quantity, and the price of each input unit is $2. Then total output 10 total input 5 Productivity = = = 2 and Per-unit Production = cost Total input costs $2 x 5 Total output 10 = = $1

21. 3. Change in legal-institutional environment a) Business taxes and subsidies Higher business taxes, such as sales, excise, and payroll taxes, increase per-unit costs and reduce aggregate supply in much the same way as a wage increase. Similarly, a business subsidy--as payment or tax break by government to firms--reduces production costs and increases aggregate supply.

22. 3. Change in legal-institutional environment b) Government regulations It is usually costly for businesses to comply with government regulations. Therefore, regulation increases per-unit production costs and shifts the aggregate supply curve leftward. “Supply-side” proponents of deregulation of the economy have argued forcefully that, by increasing efficiency and reducing the paperwork associated with complex regulations, deregulation will reduce per-unit costs, and shift the aggregate supply curve rightward.

23. Some determinants of aggregate supply affect only the short-term AS curve and not the long-term AS. For example, if wages increase without increasing production, the cost of production will cause the SRAS to shift but not the LRAS. However, the addition/loss of workers to the labor force, ceteris paribus, WILL cause LRAS to shift. Supply & demand in factor markets (capital, labor, land) will cause prices to change and thusly, affect only SRAS……UNLESS this is a reflection of a permanent change of those inputs. If it is permanent, it will affect LRAS. LRAS PRICE LEVEL SRAS1 SRAS0 PL1 PL0 RGDPFE Real Gross Domestic Product

24. Another influence that can cause the increase in the cost of production are natural disasters. Hurricanes, tornados, flooding, earthquakes and droughts could cause the short-run AS to shift to the left, ceretis paribus.

25. EQUILIBRIUM: REAL OUTPUT AND THE PRICE LEVEL The intersection of the Aggregate Demand Curve and the Short-Run Aggregate Supply Curve determines the equilibrium level of real output and price level. When equilibrium occurs at the potential output level (on the LRAS), the economy is operating at full-employment. LRAS PRICE LEVEL SRAS PL0 AD RGDPFE Real Gross Domestic Product

26. Shifts of the Short-Run Aggregate Supply Curve *Krugman

27. Shifts of the Short-Run Aggregate Supply Curve Changes in • Commodity prices • Nominal wages • Productivity *Krugman

28. Long-Run Aggregate Supply Curve *Krugman

29. Actual and Potential Output *Krugman

30. Economic Growth Shifts the LRAS Curve Rightward *Krugman

31. From the Short Run to the Long Run *Krugman

32. Short-run equilibrium can change when the SRAS or AD shifts rightward or leftward. However, long-run equilibrium of LRAS only changes when the LRAS curve shifts. LRAS PRICE LEVEL Economists anticipate many of the supply and demand changes. Whenever the changes are not expected, economists call them SHOCKS. SRAS PL0 AD RGDPFE Real Gross Domestic Product

33. Shifts of the SRAS Curve *Krugman

34. Short-Run Versus Long-Run Effects of a Negative Demand Shock *Krugman

35. Short-Run Versus Long-Run Effects of a Positive Demand Shock *Krugman

36. Negative Supply Shocks *Krugman

37. Another way of looking at Macroeconomic Equilibrium: As in the case of the intersection of a product’s demand curve and a product’s supply curve, we can see that the intersection of the aggregate supply curve and the aggregate demand curve determines the economy’s EQUILIBRIUM PRICE LEVEL and EQUILIBRIUM REAL DOMESTIC OUTPUT. AS PRICE LEVEL AS Equilibrium in the intermediate range of aggregate supply. PRICE LEVEL Equilibrium in the horizontal range of aggregate supply. AD AD Real Domestic Output, GDP Real Domestic Output, GDP

38. Where equilibrium occurs in the horizontal range of aggregate supply, no change in the price level accompanies the move toward equilibrium real output. Where equilibrium occurs in the intermediate range of aggregate supply, the price level will change to eliminate underproduction or overproduction of output. AS PRICE LEVEL AS PRICE LEVEL Pe P1 Pe AD AD Q1 Qe Q2 Q1 Qe Q2 Real Domestic Output, GDP Real Domestic Output, GDP

39. The effect of an increase in aggregate demand depends upon the range of the aggregate supply curve in which it occurs. An increase in aggregate demand during the horizontal range increases the real output but leaves price unaffected. An increase in aggregate demand during the vertical range increases the price level but production cannot exceed capacity. AS AS PRICE LEVEL PRICE LEVEL P6 AD6 P5 AD5 P1 AD2 AD1 Q1 Q2 Qc Real Domestic Output, GDP Real Domestic Output, GDP

40. An increase in aggregate demand during the intermediate range increases both real output and price. AS PRICE LEVEL P4 AD4 P3 AD3 Q3 Q4 Real Domestic Output, GDP

41. INFLATION AND THE MULTIPLIER In comparing the figures below, one can see that GDP increase more in figure A than in figure C, even though the shifts in AD are of equal magnitudes. When we combine the two figures we will get…….. AS AS PRICE LEVEL PRICE LEVEL P4 AD4 P3 P1 AD3 AD2 AD1 Q1 Q2 Q3 Q4 Real Domestic Output, GDP Real Domestic Output, GDP

42. An increase in aggregate demand during the horizontal range (AD1 to AD2) means that the economy is in recession…..excess production capacity and a high unemployment rate. Businesses are willing to produce more output at existing prices. An initial change in spending and resulting change in aggregate demand transmits fully into a change in real GDP and employment. The price level remains constant. AS PRICE LEVEL In the horizontal range of aggregate supply a “full-strength” multiplier is at work. FULL MULTIPLIER EFFECT P2 P1 AD3 AD2 AD1 GDP1 GDP2 GDP3 Real Domestic Output, GDP

43. If the economy is in either the intermediate or vertical range of the aggregate supply curve, part or all of any initial increase in aggregate demand will be dissipated in inflation and therefore NOT be reflected in increased real output and employment. Below, the shift from AD2 to AD3 is of the same magnitude as AD1 to AD2. Because we are in the intermediate range of the aggregate supply curve, a portion of the increase in aggregate demand is absorbed as inflation as the price level rises from P1 to P2. Real GDP rises only to GDP’. If the aggregate supply curve had been horizontal, then the shift would have increased real GDP to GDP3. AS PRICE LEVEL FULL MULTIPLIER EFFECT P2 P1 AD3 AD2 REDUCED MULTIPLIER EFFECT AD1 GDP1 GDP2 GDP3 GDP’ Real Domestic Output, GDP

44. THE RATCHET EFFECT What happens when aggregate demand decreases?? Our model suggests the following: Horizontal Range: Real GDP falls and price level remains unchanged. Vertical Range: Prices fall and real output remains at the full-capacity level. Intermediate Range: Both real output and price level diminishes.

45. The complication is that many prices (of both products and resources) rise quickly but are “sticky” or inflexible in a downward direction. Some economists call this the “ratchet effect’ because a ratchet is a mechanism that cranks a wheel forward but not backward. AS PRICE LEVEL PRICE LEVEL P6 AD6 P5 AD5 P4 AD4 P3 AD3 Q3 Q4 Qc Real Domestic Output, GDP Real Domestic Output, GDP

46. If AD increases from AD1 to AD2 the economy moves from P1Q1 equilibrium (point a) on the horizontal range to P2Qc equilibrium (point b) on the vertical range. This increase in aggregate demand has increased the price level. The higher product prices in turn result in increases in wages and increased input prices, raising per-unit production costs at each level of available GDP. AS These prices, however, do not come down very easily. Instead of the economy returning to equilibrium at point a, the higher per-unit costs remain and the aggregate supply curve will stay in place at P2cAS (point c). PRICE LEVEL c b P2 AD2 a P1 AD1 Q2 Q1 Qc Real Domestic Output, GDP

47. REASONS for DOWNWARD PRICE-LEVEL INFLEXIBILITY 1) Wage Contracts:Unions prohibit wage cuts for duration of the contract. 2) Morale, Effort, and Productivity: Lower wages may reduce worker morale and work effort, lowering productivity. 3) Training Investments: Lowering wages may cause skilled workers to quit and costs would be incurred to train the new workers. 4) Minimum Wage: Legal floor for wages for lesser skilled workers. 5) Menu Costs: The cost of changing prices (reprinting of menus & catalogs, advertising, etc.) 6) Fear of Price Wars: Concern that if one business lowers their prices, rivals will cut with deeper and deeper rounds of price cuts.

48. DEMAND-PULL INFLATION …..is when the price level rises as a result of an increase in aggregate demand. An increase in consumer optimism could spur an increase in aggregate demand. This would cause an increase in the price level and an increase in real output. Remember, businesses have an incentive to produce more when the prices of their goods are rising faster than the costs of inputs. LRAS PRICE LEVELS SRAS1 SRAS0 PL2 c Is it possible for production to exceed its potential? PL1 b PL0 a AD1 Yes….for a short time. As workers are encouraged to work overtime and part-time workers become full-time. AD0 RGDPFE Real Gross Domestic Product

49. COST-PUSH INFLATION What would happen if OPEC were to impose steep price increases on oil like they did in 1973-74??? The domestic per-unit price of producing goods would increase and drive prices up. This is what is called COST-PUSH INFLATION. LRAS PRICE LEVELS SRAS1 A shift from SRAS0 to SRAS1 would cause the economy to move from point a to b. Cost-push inflation increases from P1 to P2 and real output from RGDPFE to RGDP1. SRAS0 b P2 P1 a AD RGDP1 RGDPFE Real Gross Domestic Product

50. When OPEC imposed steep price increases on oil in 1973-74, it caused a phenomenon known as STAGFLATION through the 1970s and 80s. This is where lower growth and higher prices occur together and shown below by a leftward shift in the Aggregate Supply Curve. LRAS PRICE LEVELS SRAS1 When the Aggregate Demand Curve does not change and price level increases, then inflation is caused by supply-side forces, not demand. SRAS0 b P2 P1 a AD RGDP1 RGDPFE Real Gross Domestic Product