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

The Aggregate Supply Curve

• 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

The Aggregate Supply Curve

• 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

Equilibrium: Aggregate Demand & Supply

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

• Aggregate quantity demanded

– Inventories – increase• Prices – forced down

– Price level – falls

– Production – falls

11

Equilibrium: Aggregate Demand & Supply

• 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

Recessionary and inflationary gaps revisited

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

Recessionary and inflationary gaps revisited

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

Applying Model to a Growing Economy

• 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

Applying Model to a Growing Economy

• 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

Real GDP (Y) in Billions of 2000 Dollars

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

Real GDP (Y) in Billions of 2000 Dollars

Pric

e Le

vel (

P)

(200

0=10

0)

11,000 11,165

113115 A

D3

D3

S1

S1

E

Applying Model to a Growing Economy

• 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

Real GDP (Y) in Billions of 2000 Dollars

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