© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 1 SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE Long-Run Macroeconomic Adjustments

© 2005 McGraw-Hill Ryerson Ltd.© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14Macroeconomics, Chapter 14 11

SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGESLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

Long-Run Macroeconomic Long-Run Macroeconomic AdjustmentsAdjustments


In this chapter you will learnIn this chapter you will learn

14.114.1 To apply the long-run AD-AS To apply the long-run AD-AS model to explain inflation, model to explain inflation, recessions, and unemploymentrecessions, and unemployment

14.2 14.2 About the inflation-About the inflation-unemployment relationshipunemployment relationship

14.314.3 The long-run Phillips Curve The long-run Phillips Curve14.414.4 About the effects of taxation on About the effects of taxation on

aggregate supplyaggregate supply


Chapter 14 TopicsChapter 14 Topics

14.114.1 Applying the Long-Run AD-AS Applying the Long-Run AD-AS ModelModel

14.214.2 The Inflation-Unemployment The Inflation-Unemployment RelationshipRelationship

14.314.3 The Long-Run Phillips Curve The Long-Run Phillips Curve

14.414.4 Taxation & Aggregate Supply Taxation & Aggregate Supply


Applying the Long-Run AD-Applying the Long-Run AD-AS ModelAS Model

Demand-pull inflation occurs when Demand-pull inflation occurs when an increase in aggregate demand an increase in aggregate demand pulls up the price levelpulls up the price level

Pri

ce

Lev

el

Real domestic product

o

AS1

Demand-Pull InflationDemand-Pull Inflation

P1

GDPf

The startingThe startingpoint is fullpoint is fullemploymentemploymentGDP (GDPGDP (GDPf f ))

AD1

Figure 14-1Figure 14-1


o

AS1

P1

Something Something causes AD to causes AD to increase…increase…what are some what are some possibilities?possibilities?

AD1


Pri

ce

Lev

el

GDPf




o

AS1

P1

Higher Higher demanddemandleads to aleads to ahigher price higher price level, and level, and higher outputhigher output

AD1

P2

AD2

GDP2


Pri

ce

Lev

el

GDPf




o

AS1

P1

AD1

P2

AD2

GDP2

A higher priceA higher pricelevel (Plevel (P2 2 ) )

EVENTUALLYEVENTUALLYleads to higherleads to highernominal wagesnominal wageswhich causes....which causes....


Pri

ce

Lev

el

GDPf




o

AS1

P1

P3

GDP2

AD2

A left shift ofA left shift ofthe short runthe short runAS curveAS curve

AS2

P2

AD1


Pri

ce

Lev

el

GDPf






in the short run, demand-pull in the short run, demand-pull inflation drives up prices and outputinflation drives up prices and output

in the long run, output is restored to in the long run, output is restored to GDPGDPff and only the price level is and only the price level is

higherhigher


Cost-Push InflationCost-Push Inflation

Cost-push inflation arises from Cost-push inflation arises from factors that increase the cost of factors that increase the cost of production at each price levelproduction at each price level

o

AS1

P1

GDPf

Something Something drives up drives up production production costs…such costs…such as?as?

AD1

Cost-Push InflationCost-Push InflationFigure 14-2Figure 14-2

Pri

ce

Lev

el

ASLR



o

AS1

P1

AS shifts to AS shifts to the left, the left, leading to leading to higher higher prices and prices and lower outputlower output

AD1

AS2

P2

Pri

ce

Lev

el


GDP2 GDPf

ASLR



o

AS1

P1

Now what?Now what?

Left alone, the Left alone, the economy will economy will eventually eventually make its way make its way back to GDPback to GDPff

AD1

AS2

P2

HOW?

Pri

ce

Lev

el


GDPfGDP2

ASLR



o

AS1

P1

Layoffs, high Layoffs, high unemployment unemployment will eventually will eventually lead to lower lead to lower factor pricesfactor prices

AD1

AS2

P2

Pri

ce

Lev

el


GDPfGDP2

ASLR



o

AS1

P1

What other What other options are options are there?there?

AD1

AS2

P2

Pri

ce

Lev

el


GDPfGDP2

ASLR



o

AS1

P1

Expansionary Expansionary fiscal or fiscal or monetary monetary policypolicy

AD1

AS2

P2

AD2

P3

Pri

ce

Lev

el


GDPfGDP2

ASLR



o

AS1

P1

But this leads But this leads to higher to higher inflationinflation

AD1

AS2

P2

AD2

P3

Pri

ce

Lev

el


GDPfGDP2

ASLR




Cost-Push InflationCost-Push Inflation if government attempts to maintain if government attempts to maintain

full employment, an inflationary full employment, an inflationary spiral may occurspiral may occur

otherwise, there will be a recession, otherwise, there will be a recession, with high unemployment and a loss with high unemployment and a loss of outputof output


Recession & the Long-Run Recession & the Long-Run AD-AS ModelAD-AS Model

how long would it take in the real how long would it take in the real world for price & wage adjustments world for price & wage adjustments to occur, to regain full employment?to occur, to regain full employment?

there is disagreement among there is disagreement among economists about how longeconomists about how long








The Inflation-Unemployment The Inflation-Unemployment RelationshipRelationship

Under normal circumstances, there is a Under normal circumstances, there is a short-run tradeoff between inflation & short-run tradeoff between inflation & unemploymentunemployment

Aggregate supply shocks can cause both Aggregate supply shocks can cause both higher inflation & higher unemploymenthigher inflation & higher unemployment

There is no significant tradeoff between There is no significant tradeoff between inflation & unemployment over long inflation & unemployment over long periods of timeperiods of time


The Phillips CurveThe Phillips Curve

Assuming a constant AS, high rates Assuming a constant AS, high rates of inflation are accompanied by low of inflation are accompanied by low rates of unemployment, & vice-versarates of unemployment, & vice-versa

illustrated…illustrated…

o

P0

GDP0

AS

AD0

The Phillips CurveThe Phillips CurveFigure 14-4Figure 14-4

Pri

ce

Lev

el



o

P0

P1

GDP0 GDP1

AS

AD0

AD1


Pri

ce

Lev

el



o

P0

P1

P2

GDP0 GDP1GDP2

AS

AD0

AD1

AD2


Pri

ce

Lev

el



o

P0

P1

P2

P3

GDP0 GDP1GDP2GDP3

AD0

AD1

AD2

AD3

AS


Pri

ce

Lev

el




Phillips CurvePhillips CurveConcept & Canadian DataConcept & Canadian Data



The Phillips CurveThe Phillips Curve

Modern economists reject the idea Modern economists reject the idea of a stable, predictable long-run of a stable, predictable long-run Phillips CurvePhillips Curve

They agree there is a They agree there is a short-runshort-run tradeoff between inflation & tradeoff between inflation & unemploymentunemployment


Aggregate Supply Shocks & Aggregate Supply Shocks & the Phillips Curvethe Phillips Curve

In the late 1970s and early 1980s, In the late 1970s and early 1980s, the economy experienced the economy experienced stagflationstagflation

AdverseAdverse

AggregateAggregate

SupplySupply

ShocksShocks


Adverse Aggregate Supply Adverse Aggregate Supply ShocksShocks

OPEC and Energy PricesOPEC and Energy Prices Other shocks:Other shocks:

– agricultural shortfallsagricultural shortfalls– dollar depreciationdollar depreciation– wage increases after wage-price wage increases after wage-price

controls liftedcontrols lifted– declining productivitydeclining productivity


A Shifting Phillips Curve?A Shifting Phillips Curve?Figure 14-6Figure 14-6


Stagflation’s DemiseStagflation’s Demise

by the late 80’s, it appeared the by the late 80’s, it appeared the Phillips curve had shifted backPhillips curve had shifted back– recession of 81-83recession of 81-83– increased foreign competitionincreased foreign competition– deregulation of airlines and truckingderegulation of airlines and trucking– decline in OPEC’s powerdecline in OPEC’s power








The Long-Run Phillips The Long-Run Phillips CurveCurve

There is no apparent long-run There is no apparent long-run tradeoff between inflation & tradeoff between inflation & unemploymentunemployment

An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PC1

a1

PCLR

Unemployment rate (per cent)

0

3

6

9

12

15

The Long-Run Phillips CurveThe Long-Run Phillips CurveFigure 14-7Figure 14-7

economy is at aeconomy is at a11

with unemployment with unemployment at 5%, and inflation at 5%, and inflation

at 3%; suppose at 3%; suppose wages are set on the wages are set on the

assumption of 3% assumption of 3% inflationinflation


An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15

The Long-Run Phillips CurveThe Long-Run Phillips Curve

suppose AD suppose AD increases & inflation increases & inflation

increases to 6%; increases to 6%; economy moves to economy moves to

bb11

b1



An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15


but bbut b11 is not a stable is not a stable

equilibrium; workers equilibrium; workers will demand higher will demand higher wages; economy wages; economy

moves to amoves to a22

b1

a2



An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15


Phillips Curve shifts Phillips Curve shifts upward from PCupward from PC11 to to

PCPC22

b1

a2

PC2



An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15


scenario repeats if scenario repeats if AD increases againAD increases again

b1

a2

PC2

b2a3

PC3

so any rate of so any rate of inflation is possible inflation is possible with the 5% natural with the 5% natural

rate of rate of unemploymentunemployment

so any rate of so any rate of inflation is possible inflation is possible with the 5% natural with the 5% natural

rate of rate of unemploymentunemployment



An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PC1

a1

PCLR


0

3

6

9

12

15


b1

a2

PC2

b2a3

PC3the long-run Phillips the long-run Phillips Curve is vertical at Curve is vertical at the 5% natural rate the 5% natural rate of unemploymentof unemployment

the long-run Phillips the long-run Phillips Curve is vertical at Curve is vertical at the 5% natural rate the 5% natural rate of unemploymentof unemployment



An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PCLR


a3

PC3

0

3

6

9

12

15

c3


what about what about disinflation?disinflation?

suppose the suppose the economy is at aeconomy is at a33 & &

AD declinesAD declines



An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PCLR


a3

PC3

0

3

6

9

12

15

c3


firms & workers firms & workers eventually adjust to eventually adjust to lower 6% inflationlower 6% inflation

PC2

a2



An

nu

al r

ate

of

infl

atio

n(p

erce

nt)

3 4 5 6

PCLR


a3

PC3

0

3

6

9

12

15

c3


if AD falls further, the if AD falls further, the scenario will scenario will

continuecontinuePC2

a2

c2

PC1

a1










Taxation & Aggregate Taxation & Aggregate SupplySupply

Government policies can impede or Government policies can impede or promote rightward shifts of ASpromote rightward shifts of AS

Effects of taxation on the supply Effects of taxation on the supply curve are key concerns of curve are key concerns of supply supply side economicsside economics


Taxes & Incentives to WorkTaxes & Incentives to Work

Reductions in marginal tax rates on Reductions in marginal tax rates on earned incomes induce more workearned incomes induce more work

Lower marginal tax rates make Lower marginal tax rates make leisure relatively more expensiveleisure relatively more expensive


Incentives to Save & InvestIncentives to Save & Invest

Lower marginal tax rates increase Lower marginal tax rates increase the rewards for saving & investingthe rewards for saving & investing

Saving is a prerequisite for Saving is a prerequisite for investmentinvestment


The Laffer CurveThe Laffer Curve

It is possible that reductions in It is possible that reductions in marginal tax rates will increase AS marginal tax rates will increase AS but leave tax revenues unchangedbut leave tax revenues unchanged

illustrated…illustrated…

Laffer CurveLaffer Curve

Tax revenue (dollars)0

100

Shows impact of tax ratesupon tax collections

Tax

rat

e (p

erce

nt)





100T

ax r

ate

(per

cen

t)

l

increase tax increase tax rates and tax rates and tax

revenues revenues increaseincrease

increase tax increase tax rates and tax rates and tax

revenues revenues increaseincrease





100

m m

Tax

rat

e (p

erce

nt)

l

tax revenues tax revenues increase at a increase at a decreasing decreasing

rate as rates rate as rates rise furtherrise further

tax revenues tax revenues increase at a increase at a decreasing decreasing

rate as rates rate as rates rise furtherrise further





100

m m

Tax

rat

e (p

erce

nt)

n

l

at some at some point, rates point, rates are so high are so high

that that economic economic

activity activity decreases, decreases,

and cheating and cheating increasesincreases

at some at some point, rates point, rates are so high are so high

that that economic economic

activity activity decreases, decreases,

and cheating and cheating increasesincreases





100

m m

Tax

rat

e (p

erce

nt)

n

l




Criticisms of the Laffer CurveCriticisms of the Laffer Curve

Taxes, Incentives and TimeTaxes, Incentives and Time– substitution effect as well as income substitution effect as well as income

effecteffect InflationInflation

– demand side effects may be demand side effects may be greater/quickergreater/quicker

Position on CurvePosition on Curve– where are we?where are we?







Documents

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 14 1 SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE Long-Run Macroeconomic Adjustments