Lecture Macroeconomics - Chapter 15: Long run macroeconomic adjustments

Chapter 15 - Long run macroeconomic adjustments. After studying this chapter you will be able to understand: To apply the long-run AD-AS model, about the inflation-unemployment relationship, about the effects of taxation on aggregate supply.

Chapter 15

Long Run Macroeconomic

Adjustments

In this chapter you will learn

To apply the long-run AD-AS model

About the inflation-unemployment

relationship

About the effects of taxation on

aggregate supply

Applying the Long-Run

AD-AS Model

Demand-pull inflation occurs when

an increase in aggregate demand

pulls up the price level

Figure 15-1

PL1

Something causes AD to increase…

what are some possibilities?

PL1

Higher demand leads to a higher price level, and higher output

Demand-Pull Inflation

in the short run, demand-pull

inflation drives up prices and output

in the long run, output is restored to

Cost-Push Inflation

Cost-push inflation arises from

factors that increase the cost of

production at each price level

PL1

Something drives up production costs…such as?

PL1

AS shifts to the left,

leading to higher

prices and lower output

make its way

PL1

Layoffs, high unemployment will eventually lead to lower factor prices

PL1

What other options are there?

PL1

Expansionary fiscal or

PL1

But…workers have suffered real wage

Cost-Push Inflation

if government attempts to maintain

full employment, an inflationary

spiral may occur

otherwise, there will be a recession,

with high unemployment and a loss

of output

Recession & 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?

probably a long time

The Inflation-Unemployment

Relationship

Under normal circumstances, there is a

short-run tradeoff between inflation &

unemployment

Aggregate supply shocks can cause both

higher inflation & higher unemployment

There is no significant tradeoff between

inflation & unemployment over long

The Phillips Curve

Assuming a constant AS, high rates

of inflation are accompanied by low

rates of unemployment, &

vice-versa

7 6 5 4 3 2

Data for the 1960s Figure 15-5

61 62

63 64

1960s data seemed

to confirm the Phillips Curve relationship

The Phillips Curve

Modern economists reject the idea

of a stable predictable Phillips

Curve

between inflation & unemployment

Adverse Supply Shocks

In the late 1970s and early 1980s,

the economy experienced

stagflation

Aggregate Supply Shocks

Aggregate Supply Shocks

OPEC and Energy Prices

Shifting Phillips Curve?

PC1 PC2

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

The Long-Run Phillips

Curve

There is no apparent long-run

tradeoff between inflation &

unemployment

The Long-Run Phillips Curve

Figure 15-7

economy is at a1 with unemployment at 5%, and inflation at 3%; suppose wages

are set on the assumption of 3%

inflation

The Long-Run Phillips Curve

Figure 15-7

suppose AD increases & inflation increases to 6%; economy moves to

b1

b1

The Long-Run Phillips Curve

Figure 15-7

but b1 is not a stable equilibrium; workers will demand higher wages; economy

b1 a2

The Long-Run Phillips Curve

The Long-Run Phillips Curve

rate of unemployment

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

rate of unemployment

The Long-Run Phillips Curve

of unemployment

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

of unemployment

The Long-Run Phillips Curve

Figure 15-7

what about disinflation?

suppose the economy is at a3 &

AD declines

a2

Taxation & Aggregate

Supply

Government policies can impede or

promote rightward shifts of AS

Taxation & Aggregate

Supply

Supply-siders argue that high

marginal tax rates are impeding

productivity growth

Taxes & Incentives to Work

Incentives to Save & Invest

The Laffer Curve

It is possible that reductions in

marginal tax rates will increase AS

but leave tax revenues unchanged

Laffer Curve

100

Shows impact of tax rates

upon tax collections

increase tax rates and tax revenues increase

Figure 15-8

tax revenues increase at a decreasing rate as rates rise further

Figure 15-8

that economic activity decreases, and cheating

at some point, rates are so high

that economic activity decreases, and cheating

Figure 15-8

Criticisms of the Laffer Curve

Taxes, Incentives and Time

– substitution effect as well as income

effect

Inflation

– demand side effects may be

greater/quicker