Two things to learn: Use extended AS/AD model. Use short run and long run Phillips curve and PPF

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Cecil Floyd
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1 Two things to learn: Use extended AS/AD model Use short run and long run Phillips curve and PPF 1

2 IN THE LONG RUN WE ALWAYS END UP AT THE SECOND GRAPH: SRAS SRAS AD AD How? WE MUST KNOW THE PATTERN OF EVENTS THAT MAKES THIS HAPPEN. THERE ARE FOUR POSSIBLE STARTING EVENTS AND MORE POSSIBLE SUBSEQUENT RESULTS. 2

3 SRAS 1 SRAS 0 SRAS 0 SRAS 1 AD AD A B SRAS SRAS AD 1 AD 0 AD 0 AD 1 A D 3

4 Definition of the long run: Wages are fully responsive(any flattening of supply curve disappears). o firms break worker inflexibility on downside wages. o increased wages can not persistently draw more workers. SRAS Temporary imbalances in MRP/MRC dissipate => producers move away from temporarily paying high marginal costs to respond to demand. AD Conclusion: The price level will adjust to any level necessry support the level of production. 4

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6 First set of graphs: Tell story if we are off equilibrium, what happens 6

7 Generically if we are above SRAS 2 SRAS 0 1 P 1 P 0 Something moves AD^ =>Q^ In the long run Q 1 is unsustainable. Key assumption: Workers who are drawn to make extra production, Q 1 Q 0, made their decision based on Price level 0. When we move to P 1, these new workers AND the old workers have lower REAL wages. AD 0 All workers insist on not losing ground in wages. Q SRAS 2 occurs. 0 Q 1 AD 1 =>P^ =>Real Wages v=>wage Demands ^=>Input prices ^=>ASv =>P^Qv, until 1 2 7

8 Generically if we are below SRAS 0 1 P 0 AD 0 In the long run Q1 is unsustainable. Key assumption: Unemployed workers, Q 1 Q 0, eventually reduce their wage demands. Unemployed workers have no wages AND Workers begin to give ground on wages in favor of employment. SRAS 2 occurs. Q 1 Q 0 Q below =>Unempl. > NRU =>Wages v=>input prices v=>as ^ =>PvQ^, until SRAS 2 AD P 1 8

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11 Demand pull inflation SRAS 0 1 Put more briefly and starting on the demand pull inflation example: P 1 P 0 1) C,G,I,X changes pushed demand past. 2) There are temporary (short runs) 3) Real wage effects move SRAS in the long run. AD 0 Q 0 SRAS 2 Q AD 1 11

12 SRAS 0 1 Recession, AD drops. P 0 Q 1 Q 0 AD 1 Key assumption: Workers lost jobs moving from Q 0 Q 1, are looking to work. AD 0 When we move to P 0, these fired workers have no wages AND the old workers have REAL higher, expensive wages. Workers begin to give ground on wages in favor of employment. SRAS 2 occurs. P 1 SRAS

13 We start off of equilibrium: AS responds We start at equilibrium & something happens moving us off. No matter what moved us off, AS gets us back Why? is about resources Being off is about under or over utilized resources, specifically labor. So the mechanism that gets us back is the imbalance in the market for labor. 13

14 SRAS 1 SRAS 0 SRAS 0 SRAS 1 AD AD A B SRAS 0 SRAS1 SRAS 0 SRAS 1 AD 1 AD 0 AD 0 AD 1 A D 14

15 What is a government to do? Part 1 Some points about recession. SRAS 0 1 P 0 P 1 Tough to buy into the idea that the world plays out exactly as we have said: 1) Wages must have downward flexibility 2) The government must decide to sit on its hands. 1 AD 0 2 Q 1 Q 0 AD 1 So, 1) Tests will often simplify by saying assume wages are flexible. And 2) Government is in a tougher spot figuring out what to do (see next) SRAS 2 15

16 What is a government to do? Part 2 Some points about recession. SRAS 0 1 Stimulate to cut unemployment. (Fiscal or monetary) P 0 P 1 1 Risk kicking off inflation, but not a huge risk. AD 0 2 AD 1 SRAS 2 Q 1 Q 0 16

17 Recession. SRAS 0 1 SRAS 2 P 0 P 1 Tough to buy into this story: 1) Wages must have downward flexibility 2) The government must decide to sit on its hands. 1 AD 0 AD 1 Q 1 Q

18 With the "if" qualifier, the following is a generally uncontroversial statement: If anything other than balanced at all times run surpluses when economy is good and deficits when it is bad, which should happen naturally. When you have not done this and you have a huge accumulated debt you have a tough problem: Pure Keynesian: Do expansionary policy anyway. Alternative: Debt level makes investment environment uncertain. Do not make that problem worse. 18

19 P 0 SRAS 1 SRAS 0 Cost push inflation. 1) Due to events unit costs go up. GDP,P 2) Below, we assume unemployment above NRU, so government is concerned. => Stimulates (fiscal or monetary) creating AD 2 Problem: Formula for inflationary spiral. AD 0 1 Q 0 OK, let's change step 2. AD P 1 Q 1 19

20 P 0 Q 1 Q 0 SRAS 1 SRAS 0&2 AD 0 3 Cost push inflation. 1) Due to events unit costs go up. GDP,P 2) Fearing inflationary spiral government does nothing. Eventually, unemployed workers offer themselves at lower wages. 3) Wage cuts reduce unit costs, until effect of original unit cost jump are nuetralized. Note: If the event is an increase in cost of an input other than wages, then this process moves compensation to that resources at the expense of workers. 2 NO EASY WAY OUT: 1 Choice 1: Cause greater inflation and risk inflationary spiral. P 1 Choice 2: Wait out unemployment and loss of output 20

21 1) When we go off, AS will move us back in the long run. 2) When we are off, the government must assess the situation and decide: Act/change policy Wait 3) Four cases: Acting is an easier* call below, but o Increases debt o Risks inflation* Not acting is easier above, but o Foregoes the opportunity for surplus 21

22 Case not discussed SRAS 0 SRAS 1 P 0 P AD 0 AD 1 Q 0 Q 1 22

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26 If AD is shocked, then AS adjusts through wages and employment trade offs. One curve reacts to the other If AS is shocked, then AS adjusts through wages and employment trade offs. AS returns itself to BUT... 1) The government may not have patience for unemployment scenarios. 2) Wages may be sticky downward. 26

27 1) First Phillips curve idea: There is a direct trade off between inflation and unemployment. Our current assumptions/graph imply the following idea: Rising price levels are associated with lower levels of unemployment. Falling prices are associated with higher unemployment. Phillips Curve SRAS Annual inflation rate AD Unemployment rate 27

28 2) Second Phillips curve idea: The trade off can change. Historic data initially supported Phillips, but then did not. BUT an explanation was found. The basic Phillips curve assumes a given supply curve. If the supply curve jumps the Phillips curve does also. Phillips Curve SRAS 1 SRAS Annual inflation rate AD Unemployment rate 28

29 1) AD moves shift us along Phillips curve, as long as SRAS stays still. 2) AS moves shift the Phillips curve itself 29

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33 3) Third Phillips curve idea. There is no unemployment/inflation trade off in the long run. Phillips Curve Long run Phillips Growth pressure At A inflation is and has been eroding real wages. Workers ask for higher real wages. This cuts the profitability of production. Employers produce less, and employ less Until we get to NRU (This is consistent with wage demands move AS until ). Recession pressure Recession cuts sales=>revenue=>profits. Employers look to cut prices, but need to cut expense Lower production and looking to lower expense, workers are fired. On next wage negotiation workers take lower wages and more are employed. Reducing inflation and decreasing unemployment. Annual inflation rate A B Unemployment rate 33

34 Which dot is consistent with growth? Which dot is consistent with recession? Inflation Unemployment goto16y8 34

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Expansionary Fiscal Policy 2. If the economy is experiencing a recession what type of fiscal policy would be in order?

Expansionary Fiscal Policy 2. If the economy is experiencing a recession what type of fiscal policy would be in order? Stabilization Policies Reading Guide Chapters 12, 16, and 18 Chapter 12: Fiscal Policy 1. Assess the effect of fiscal policy on real output, price level, and the level of employment in the long run and