PART 5: THE LONG RUN AND CURRENT ISSUES IN MACRO THEORY AND POLICY CHAPTER 15 Long-Run Macroeconomic Adjustments Slides prepared by Bruno Fullone, George Brown College 2010 McGraw-Hill Ryerson Limited 1
In This Chapter You Will Learn Learning Objective 15.1: How the economy arrives at its long-run equilibrium Learning Objective 15.2 : How to apply the long-run AD AS model to explain inflation, recessions, and growth Learning Objective 15.3 About the short-run tradeoff between inflation and unemployment (the Phillips Curve) Learning Objective 15.4 : Why there is no long-run tradeoff between inflation and unemployment Learning Objective 15.5 : The relationship among tax rates, tax revenues, and aggregate supply 2
15.1 From the Short Run to the Long Run Short run Input prices are inflexible aggregate supply curve is upwardly sloping Long run Input prices are fully flexible Vertical aggregate supply The transition? 3
Short-Run AS to the Long-Run AS Production above potential output: High demand for inputs Input prices rise Short run aggregate supply shifts left Return to potential output Production below potential output Graphical examples LO15.1 4
Figure 15-1 From Short-Run to Long-Run Price Level Price Level Short-Run Aggregate Supply Long-Run Aggregate Supply P 2 a 2 AS 1 P 2 AS LR b 1 AS 2 AS 1 AS 3 a 2 P 1 a 1 P 1 a 1 P 3 a 3 P 3 a 3 c 1 GDP3 GDPf GDP2 GDPf Real Domestic Output Real Domestic Output LO15.1 5
Price Level Figure 15-2 Equilibrium in the Long-Run AD-AS Model AS LR AS 1 P 1 a AD 1 GDPf Real Domestic Output LO15.1 6
15.2 Applying the Long-Run AD-AS Model Demand-pull inflation occurs when an increase in aggregate demand pulls up the price level LO15.2 7
Price Level Demand-Pull Inflation in the Long-Run AD-AS Model Figure 15-3 P 2 P 1 AD 1 AD 2 ASLR - Higher demand leads to a higher price level, and higher output - A higher price level (P2 ) EVENTUALLY leads to higher nominal wages which causes... AS 1 1. The starting point is full employment GDP (GDP f ) 2. AD increase o GDP f GDP 2 Real domestic product LO15.2 8
Demand-Pull Inflation in the Long-Run AD-AS Model Price Level Figure 15-3 AD 2 ASLR AS 2 AD 1 AS 1 P 3 P 2 P 1 - A left shift of the short run AS curve - Real output then return to its prior level and the price rises even more o GDP f GDP 2 Real domestic product LO15.2 9
In the short run, demand-pull inflation drives up prices and output In the long run, output is restored to GDP f and only the price level is higher LO15.2 10
Demand-Pull Inflation In the short run, demand-pull inflation drives up prices and output In the long run, output is restored to GDP f and only the price level is higher LO15.2 11
Price Level Demand-Pull Inflation in the Long-Run AD-AS Model AS LR AS 2 AS 1 P 3 P 2 P 1 b a c AD 1 AD 2 GDPf GDP2 Real Gross Domestic Product LO15.2
Cost-Push Inflation Cost-push inflation arises from factors that increase the cost of production at each price level LO15.2 13
Price Level Cost-Push Inflation in the Long-Run AD-AS Model AS 2 Figure 15-4 P 2 P 1 o AD 1 AS LR GDP 2 GDP f Real domestic product AS 1 Cost-push inflation occurs when AS shifts to the left, leading to higher prices and lower output LO15.2 14
Cost-Push Inflation in the Long-Run AD-AS Model Price Level Figure 15-4 AD 1 AS LR AS 2 AS 1 P 2 P 1 Layoffs, high unemployment will eventually lead to lower factor prices o GDP 2 GDP f Real domestic product LO 15.2 15
Cost-Push Inflation in the Long-Run AD-AS Model Price Level Figure 15-4 AD 2 AS LR AS 2 P 3 AD 1 AS 1 P 2 Leads to high Inflation P 1 Expansionary fiscal or monetary policy o GDP 2 GDP f Real domestic product LO15.2 16
Cost-Push Inflation: Policy Dilemma If government attempts to maintain full employment, an inflationary spiral may occur Otherwise, the recession will linger, with high unemployment and a loss of real output LO15.2 17
Recession in the Long-Run AD-AS Model Price Level Figure 15-5 P 1 AD 2 AD 1 AS LR AS 1 AS 2 Recession Occur AD 1 AD 2, P 1 P 2, GDP f GDP 1 P 2 P 3 Lower wage AS 1 -AS 2, restore GDP, P 2 further Reduce to P 3 o GDP 1 GDP f Real domestic product LO15.2 18
Recession and the Long-Run AD-AS Model How long would it take in the real world for price & wage adjustments to occur to regain full employment? There is disagreement among economists LO15.2 19
Ongoing Inflation in the Long-Run AD-AS Model modern economies tend to experience positive rates of inflation due to economic growth causing rightward shifts of the AS curve central banks then cause rightward shifts of the AD curve so that it proceeds just a little faster than the deflationary rightward shifts of the AS curve the net effect is (usually) a small positive rate of inflation LO15.2 20
Long-Run AD-AS Model economic growth causes increases in long-run aggregate supply whether deflation, or inflation accompanies growth depends on the extent to which aggregate demand increases relative to aggregate supply any inflation that occurs is the result of growth of aggregate demand it is not the result of the growth of real GDP LO15.2 21
The Inflation-Unemployment Relationship Under normal circumstances, there is a shortrun tradeoff between inflation & unemployment Aggregate supply shocks can cause both higher inflation & higher unemployment There is no significant tradeoff between inflation & unemployment over long periods of time LO 15.3 22
The Phillips Curve Assuming a constant AS, high rates of inflation are accompanied by low rates of unemployment, & vice-versa illustrated LO15.3 23
Price Level The SR Effects of Changes in AD on Real Output and the Price Level Figure 15-9 P 3 AS AD 3 P 2 P 1 AD 2 P 0 o AD 0 AD 1 GDP 0 GDP 1 GDP 2 GDP 3 Real domestic product LO15.3 24
Inflation Phillips Curve: Concepts and Canadian Data Figure 15-8 8 7 6 A Negative relationship between inflation and unemployment 5 4 3 2 1 68 66 67 65 69 64 63 62 61 0 0 1 2 3 4 5 6 7 8 Unemployment Rate LO15.3 25
The Phillips Curve Modern economists reject the idea of a stable, predictable long-run Phillips Curve They agree there is a short-run tradeoff between inflation & unemployment LO15.3 26
Aggregate Supply Shocks and the Phillips Curve In the late 1970s and early 1980s, the economy experienced stagflation LO15.3 27
Adverse Aggregate Supply Shocks OPEC and Energy Prices Other shocks: agricultural shortfalls dollar depreciation wage increases after wage-price controls lifted declining productivity LO15.3 28
Figure 15-10: Inflation Rates and Unemployment Rates in Canada LO15.3 29
Stagflation s Demise by the late 80s, it appeared the Phillips curve had shifted back recession of 81-83 increased foreign competition deregulation of airlines and trucking decline in OPEC s power these factors also helped to reduce per-unit production costs and to shift the short-run AS curve rightward LO15.4 30
15.4 The Long-Run Phillips Curve There is no apparent long-run tradeoff between inflation & unemployment LO15.4 31
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 12 9 PC 1 PC LR Economy is at a 1 with unemployment at 5%, and inflation at 3%; suppose wages are set on the assumption of 3% inflation 6 3 a 1 0 3 4 5 6 Unemployment rate (percent) LO15.4 32
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 12 9 PC 1 PC LR Suppose AD increases & inflation increases to 6%; economy moves to b 1 6 b 1 3 a 1 0 3 4 5 6 Unemployment rate (percent) LO15.4 33
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 12 9 PC 1 PC LR But b 1 is not a stable equilibrium; workers will demand higher wages; economy moves to a 2 6 b 1 a 2 3 a 1 0 3 4 5 6 Unemployment rate (percent) LO15.4 34
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 12 PC 2 PC LR Phillips Curve shifts upward from PC 1 to PC 2 PC 1 9 6 b 1 a 2 3 a 1 0 3 4 5 6 Unemployment rate (percent) LO15.4 35
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 12 PC 2 PC 3 PC LR Scenario repeats if AD increases again 9 6 PC 1 b 2 a 3 b 1 a 2 So any rate of inflation is possible with the 5% natural rate of unemployment 3 a 1 0 3 4 5 6 Unemployment rate (percent) LO15.4 36
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 PC LR PC 3 12 9 PC 2 PC 1 b 2 a 3 The long-run Phillips Curve is vertical at the 5% natural rate of unemployment 6 b 1 a 2 3 a 1 0 3 4 5 6 Unemployment rate (percent) LO15.4 37
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 PC 3 PC LR What about disinflation? 12 9 a 3 Suppose the economy is at a 3 & AD declines 6 c 3 3 0 3 4 5 6 Unemployment rate (percent) LO15.4 38
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 12 PC 2 PC 3 PC LR Firms & workers eventually adjust to lower 6% inflation 9 a 3 6 a 2 c 3 3 0 3 4 5 6 Unemployment rate (percent) LO15.4 39
Annual rate of inflation (percent) The Long-Run Phillips Curve Figure 15-11 15 12 PC 2 PC 3 PC LR If AD falls further, the scenario will continue PC 1 9 a 3 6 a 2 c 3 3 a 1 c 2 0 3 4 5 6 Unemployment rate (percent) LO15.4 40
15.5 Taxation and Aggregate Supply Government policies can impede or promote rightward shifts of AS Effects of taxation on the supply curve are key concerns of supply side economics LO15.5 41
Taxes and Incentives to Work Reductions in marginal tax rates on earned incomes induce more work Lower marginal tax rates make leisure relatively more expensive LO15.5 42
Incentives to Save and Invest Lower marginal tax rates increase the rewards for saving & investing Saving is a prerequisite for investment LO15.5 43
The Laffer Curve It is possible that reductions in marginal tax rates will increase AS but leave tax revenues unchanged illustrated LO15.5 44
Tax rate (percent) The Laffer Curve Figure 15-12 100 Shows impact of tax rates upon tax collections Lower Tax Revenue Above m m Maximum Tax Revenue 0 Tax revenue (dollars) LO15.5 45
Criticisms of the Laffer Curve Taxes, Incentives and Time empirical evidence shows the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge Inflation demand side effects may be greater/quicker and certain Position on Curve where are we? LO15.5 46
The Last Word: Do Tax Increases Reduce Real GDP? New findings suggest tax increases reduce real GDP (Romer and Romer 2008) Positive output shocks raise tax revenues Difficult to separate effects of tax changes from other effects Investment falls sharply in response to tax changes
Chapter 15 Summary 15.1 From the short run to the long run 15.2 Applying the long-run AD AS model 15.3 The inflation unemployment relationship 15.4 The long-run Phillips curve 15.5 Taxation and aggregate supply chapter 15 48