EXTENDING the ANALYSIS of AGGREGATE SUPPLY:

 

SHORT-RUN vs. LONG-RUN AGGREGATE SUPPLY:

1.  SHORT-RUN:

Ø      Nominal wages and other input prices remain constant (fixed) as the price level changes.

Ø      Workers may not realize that their real wages have changed due to inflation (or deflation) and therefore have not adjusted their labor supply and wage decisions.

Ø      Workers hired under fixed wage contracts are “stuck” with their current wages regardless of price level changes.

2.  LONG-RUN:

Ø      Nominal wages are fully responsive to changes in the price level.

Ø      The LRAS (long-run aggregate supply) curve is a vertical line at the full-employment level of real GDP.

 

 

3 ASSUMPTIONS in CONSTRUCTING A SHORT-RUN AGGREGATE SUPPLY (AS) CURVE:

1.  The initial price is given at P1.

2.  Nominal wages have been developed on the belief that this price level (P1) will remain constant.

3.  The price level is flexible (both upward and downward).

Ø      If the price level increases, businesses will earn more profits since wages will remain constant.  Due to higher profits, businesses will increase output.  (The economy moves from a1 to a2 on AS1).

Ø      If the price level decreases, businesses will earn fewer profits since wages will remain constant.  Due to lower profits, businesses will decrease output.  (The economy moves from a1 to a3 on AS1)

 

 

EXTENDED AD-AS MODEL:

1.  Includes both the SHORT-RUN and LONG-RUN AS curves.

2.  EQUILIBRIUM occurs at point “a” where AD intersects the vertical LRAS curve and the SRAS curve at the full-employment level of output.

 

 

3.  DEMAND-PULL INFLATION:

Ø      If we are in the short-run, it will cause prices and real output to increase.

Ø      If we are in the long-run, it was only cause price level to increase.

4.  COST-PUSH INFLATION:

Ø      The result of events that increase the cost of production at each price level.  For example, the increase in the price of a necessary resource.

Ø      Thus shifts the SRAS curve to the left and creates a problem for policymakers.

Ø      If the government tries to keep full employment when there is this type of inflation, the result may be an inflationary spiral.

Ø      If the government does not do anything, the result will be a recession.  In the end, the recession may eventually undo the original increase in per unit production costs, but currently unemployment and a decline in real output will occur.

 

 

 

*  We will experience a recession when the AD curve shifts to the left.  The price level will decrease if prices and wages are flexible downward.  This decrease in the price level reduces nominal wages, which, in turn, shifts the AS curve to the right (since costs of production are now less).  The price level falls and output eventually returns to the full-employment level.  This is the most controversial application of this AD-AS model!

 

PHILLIPS’ CURVE:

Ø      Shows the relationship between unemployment (u/e) and inflation!

Ø      The P.C. (Phillips’ Curve) is downward sloping because of the inverse relationship between u/e and inflation!

Ø      The policy choice is that of reducing unemployment or reducing inflation!

Ø      We normally move back along the Phillips’ Curve to reduce the unemployment rate.  It wasn’t until the 80’s that we moved down the Phillips’ Curve to drive prices down.  Prices decreased because the OPEC nations fell apart and the recession was so large that the unemployment rate increased.  The early 70’s flattened the Phillips’ Curve by legally freezing prices and wages while using expansionary monetary policy at the same time to move from point a to point c.  The unemployment rate decreased while keeping prices the same.  This was successful except when the price / wage controls were taken off and inflation sky- rocketed due to Oil War Shock!

 

THE PHILLIPS CURVE:  Unemployment vs. Inflation …

1.  Two of our main economic goals are low unemployment and low inflation.  But, are these goals really compatible?

2.  The Phillips Curve shows the relationship between unemployment and inflation.  This curve was named after AW Phillips who observed this relationship in Great Britain.

3.  Given a SRAS curve, an ­ AD will cause the price level and real output to increase.  Likewise, a ¯ AD will cause the price level and real output to decline.

4.  This tradeoff between output and inflation does not occur over long periods of time!

5.  Empirical evidence from the 1960s confirmed Phillips inverse relationship between the unemployment rate and the inflation rate in the US for 1961-1969.

 

 

6.  The stable Phillips Curve encountered a great deal of instability during the 1970s and 1980s.  The obvious inverse relationship had become highly questionable and not so clear.  One reason the relationship was no longer clear revolved around the fact that the economy of the 1970s was experiencing inflation and rising unemployment (STAGFLATION).

7.  A number of ADVERSE AGGREGATE SUPPLY SHOCKS may have caused the stagflation of the 1970s.

Ø      The major supply shock revolved around the quadrupling of oil prices by OPEC.

Ø      Other contributing factors consisted of agricultural shortcomings, the depreciation of the dollar, wage increases, and declining productivity.

Ø      Leftward shifts of the SRAS curve are important since the Phillips Curve is derived from shifting AD along a stable SRAS curve.

Ø      The “Great Stagflation” in the 1970s made it obvious that there really wasn’t a “stable” inflation/unemployment relationship.

 

STAGFLATION:  A closer look.

1.  By looking at the empirical evidence, there was a generally inward movement of inflation/unemployment points between 1982 and 1989.

2.  The recession of 1981-1982 was largely caused by a tight money policy.  Double-digit inflation was reduced and the unemployment rate increased to 9.5%.

3.  With such high numbers of unemployment, wage increases were very small and sometimes people accepted lower wages.

4.  Firms tried to keep their relative shares of the smaller markets by not increasing their prices.

5.  Foreign competition helped keep wages and price hikes down.

6.  Deregulation of the airline and trucking industries contributed to some wage and price reductions.

7.  A significant decrease in OPEC’s market power caused oil prices to drastically fall.

 

LONG-RUN VERTICAL PHILLIPS CURVE:  (Under this view, the economy is relatively stable at its full employment rate of output.)

1.  The long-run inverse relationship between the unemployment and inflation rate is questionable in the long run.

2.  A short-run tradeoff between unemployment and inflation exists, but not a long-run tradeoff.

3.  In the short run, we believe people base their expectations of future price level changes on the basis of pervious and current inflation rates.  In addition, people only gradually change their expectations and wage demands.

4.  Fully anticipated inflation in the nominal wage demands of workers results in a vertical Phillips Curve.  This happens overtime.

 

 

CHANGES in the INTERPRETATIONS of the PHILLIPS CURVE:

1.  The original idea of a stable relationship has given way to other views that place a greater emphasis on long-run effects.

2.  Most economists agree there is a short-run tradeoff (where the short run may be several years), but they believe a tradeoff in the long run is unlikely.

 

TAXATION and AGGREGATE SUPPLY:

Ø      Economic disturbances can also be generated on the supply side.

Ø      “Supply-Side” economists desire policies that promote economic growth.

 

ARGUMENTS of “SUPPLY-SIDE” ECONOMISTS:

1.  The U.S. tax system discourages incentives to work, invest, innovate, and take on entrepreneurial risks.

Ø      To entice more people to work, the government should decrease the marginal tax rates on earned income.

Ø      Unemployment compensation and welfare programs have made unemployment seem like it’s not much of a problem for some people.  Many of the government’s transfer programs tend to discourage work.

2.  High marginal tax rates decrease the payoffs for saving and investing.

Ø      One of the main determinants for investment spending is the expected after-tax return.

3.  Lower marginal tax rates may induce people more people to look for employment and to work longer.  Lower rates should decrease periods of unemployment and increase capital investment, thereby increasing worker productivity.  This, in turn, causes aggregate supply to increase (shift to the right) and therefore inflation is kept down!

 

THE LAFFER CURVE:

1.  The Laffer Curve relates tax rates and tax revenues.  It is named after the economist Arthur Laffer.

2.  As tax rates increase from 0, tax revenues increase from 0 to some maximum level (m) and then decline.

3.  Tax rates above or below the maximum rate will cause tax revenues to decline.

4.  Laffer believed that tax rates are above the optimal level.  Thus, by decreasing tax rates, the government could increase the amount of tax revenue collected.

5.  Lower tax rates would cause an increase in real output and incomes.  This, in turn, would increase the tax base.  And, supply would be primarily affected rather than demand.

 

 

2 ADDITIONAL REASONS for LOWERING the TAX RATE:  (According to “Supply-Side” Economists)

1.  Both, legal tax avoidance and illegal tax evasion decrease when taxes are lowered.

2.  Tax cuts increase production and employment.  This reduces the need for transfer payments like welfare and unemployment compensation.

 

CRITICISMS of the LAFFER CURVE:

1.  The actual impact on the incentives to work, save, and invest are relatively small.

2.  Tax cuts also increase aggregate demand.  This can fuel inflation especially if the demand impact is greater than the supply impact.

3.  It is very difficult to determine where the economy is located on the Laffer curve.

 

DISAGREEMENTS ABOUT MACRO THEORY and POLICY:

 

DISAGREEMENTS on 3 INTER-RELATED QUESTIONS:

1.  What causes instability in the economy?

2.  Is the economy self-correcting?

3.  Should the government use rules or discretion in determining economic policy.

 

HISTORY:

1.  Classical economics dominated the field of economics starting with Adam Smith (1776) and continuing until the 1930s.  Classical economists believed that full employment was normal and that the government should take a hands-off approach (laissez-faire) with regards to regulating the economy.

2.  Keynes observed in the 1930s that laissez-faire capitalism is capable of resulting in recurring recessions/depressions with significant unemployment.  Active government intervention is necessary in order to avoid wasting idle resources.

 

THE CLASSICAL VIEW:

1.  The AS curve is vertical and located at the full-employment level of real output.

2.  Real output does NOT change when the price level changes since wages and other input prices are flexible.

3.  The economy operates at its full-employment level because of Say’s Law (“supply creates its own demand”), and flexible prices and wages in cases where there maybe over-supply.

4.  Money is the stabilizing force beneath aggregate demand.  And, AD will remain stable if the supply of money is controlled with limited growth.

5.  The demand curve is stable and solely responsible for determining the price level.

6.  An increase in the money supply would shift AD to the right.  A decrease in the money supply would shift AD to the left.  However, responsive and flexible price will allow full employment output to be maintained.

 

THE KEYNESIAN VIEW:

1.  The backbone on Keynesian economics is the idea that product prices and wages are NOT flexible in the downward direction.  This idea is shown graphically as a horizontal aggregate supply curve.

2.  Thus, a decrease in real output will NOT affect the price level.  Once full employment is achieved, the AS curve will become vertical and increases in real output will cause prices to rise.

3.  Keynesians believe AD is NOT stable from one period to the next, even when there aren’t any changes in the money supply.

4.  The investment component of AD is the most sensitive.  Changes in investment will result in changes in output and employment only!  The price level will remain the same since the AS curve is horizontal.

5.  Active government policies are necessary for increasing AD and moving us toward full employment!

 

 

WHAT CAUSES MACRO INSTABILITY … The Great Depression, Recessions, Inflationary Periods, etc. (4 views)

 

MAINSTREAM VIEW:  (Prevailing view by most economists)

1.  Keynesian Based:  Focus is on aggregate demand and its components … C + Ig + G + Xn = GDP = (Aggregate Expenditures) = (Real Output)

2.  Any change in one of the spending components of the AE (aggregate expenditures) equation will cause the AD curve to shift.

3.  When the AD curve shifts, equilibrium real output, the price level, or both will change.

4.  Investment spending is quite sensitive and subject to change.

5.  Instability also results from changes with regards to supply.  For example, artificial supply restrictions, wars, or increased costs of production can ¯ supply.

6.  A decrease in supply can destabilize the economy by creating cost-push inflation and a recession at the same time.

 

MONETARIST VIEW:  (Modern form of classical economics)

1.  Money supply is the focus of monetarist theory.

2.  Price and wage flexibility created by competitive markets cause variations in product and resource prices, yet do not affect output and employment.

3.  Therefore, a competitive market system would provide a significant amount of macro stability if the government didn’t get involved.

Ø      The government is responsible for the downward inflexibility of prices and wages by creating the minimum wage law, pro-union legislation, and guaranteeing

prices for some products (like price supports for certain farm crops).

Ø      The government also adds to the economy’s business cycles by implementing monetary policies at the wrong time and in the wrong fashion.

4.  The fundamental equation for Monetarists is the Equation of Exchange:  MV = PQ

Ø      MV is the total amount of money spent, where M = Money Supply, and V = Velocity of money (# of times the average $ is spent on final goods and services per year).

Ø      PQ is the nation’s nominal GDP, where P = price level (average price at which each unit is sold), and Q = physical quantity of all goods and services produced.

Ø      Monetarists believe V (Velocity) is STABLE.  This implies that anything altering velocity must change in a gradual and predictable fashion.  In other words, people and businesses have a STABLE pattern when it comes to holding money!

Ø      If we assume velocity is stable, the equation of exchange says that there is a predictable relationship between money supply and nominal GDP (PQ).

5.  Monetarists believe the main cause of macro instability is the implementation of inappropriate monetary policy.

6.  Mainstream economists believe the main cause of macro instability is due to the volatility of investment.  They feel monetary policy should be used to stabilize the economy since changing the money supply will cause interest rates to change, thereby keeping investment and aggregate demand stable.

 

REAL BUSINESS CYCLE VIEW:  (Focuses on aggregate supply)

1.  Business cycles are the result of real factors affecting aggregate supply.  This includes events such as a decline in productivity, which causes AS to decrease.

2.  Decreases in GDP causes there to be less of a demand for money.  Here, the supply of money is decreased after the demand declined.  AD is now less, but prices remain constant since AS also decreased.

 

 

COORDINATION FAILURES:  (A 4th view)

1.  Macro instability occurs “when people do not reach a mutually beneficial equilibrium because they lack some way to jointly coordinate their actions.”

2.  There’s no coordination device for businesses and households to agree on actions that would make everyone better off.

3.  The initial problem may be due to expectations that are NOT justified.  For example, if everyone thinks that a recession is in the near future, they will cut back on spending, firms will reduce output, and the result will be a recession.  In addition, the economy may remain in a recession for awhile simply because there is a failure of households and firms to coordinate positive expectations!

 

DOES THE ECONOMY “SELF-CORRECT”?

 

NEW CLASSICAL VIEW OF SELF-CORRECTION:

1.  The economy has automatic or internal devices for self-correction according to Monetarists and Rational Expectation economists.

2.  Through an adjustment process, full employment output will be retained.

 

3.  There is disagreement over the speed of this adjustment process.

Ø      Monetarists believe gradual change exists (adaptive expectations view).  They feel that it may take 2-3 years or more for the supply curve to shift.

Ø      Rational Expectations Theory (RET) believes people anticipate some future events before they happen, thereby making change extremely fast (sometimes even instantaneous).  When there is enough information, people’s thoughts about future outcomes accurately predict that those events will occur.  RET is based upon the assumption that new information about events with certain outcomes will be processed in a timely fashion.

4.  In RET unanticipated price-level changes result in temporary changes in real output.  Firms often change their production levels in response to what they think is a relative price change in only their product.  Any change in GDP is corrected as prices are flexible.  Thus, firms will change their production back to its prior level.

5.  In RET fully anticipated price-level changes do NOT change production.  Firms continue to profit and maintain their current output levels.

 

MAINSTREAM VIEW OF SELF-CORRECTION:

1.  There is sufficient evidence that most prices and wages are NOT flexible downward over long time periods. 

2.  Despite this evidence, some parts of RET have been incorporated into the mainstream model.

3.  Downward wage inflexibility may exist because firms can’t cut wages because of the minimum wage law and fixed contracts.

4.  Firms may also fear that wage cuts may result in a lower morale, effort, and efficiency.

5.  Efficiency wages (wages higher than market wages) minimize a firm’s labor cost per unit of output.

Ø      They provide an incentive to work harder because workers won’t want to lose their above-market wage.

Ø      Since there is a greater incentive to work hard, there will typically be lower supervision costs.

Ø      Training costs will also be reduced since job-turnover will decline (because people will be satisfied with their jobs).

6.  Some people believe wages are inflexible downward because people who are already employed (insiders) keep their jobs even though others may be seeking work for lower wages (since they are currently unemployed).  Economists believe this simply because employers desire a stable work force.

 

RULES or DISCRETION?

Ø      Monetarists and other new classical economists would support policy rules for stabilizing the economy.

Ø      Monetary Rule:  A rule that would make the Fed increase the money supply each year at the same annual rate as the normal GDP growth rate.  This rule would link increases in the LRAS with increases in the money supply so that AD is shifting rightward at the same time.  Therefore, we can obtain growth without the price level fluctuating.

 

 

Ø      Some economists desire an amendment to the constitution that would force the government to have an annually balanced budget.

Ø      Others simply think the government should be “passive” when implementing fiscal policy.  They also feel that the government should NOT run on budget deficits or surpluses on purpose.

Ø      Monetarists and other new classical economists feel that fiscal policy is useless.  They particularly feel expansionary policy is NOT any good due to the crowding out of private investment.

Ø      RET economists feel discretionary fiscal and monetary policy are ineffective since people fully anticipate the effects.

Ø      Mainstream economists support discretionary policies to stabilize the economy.  They are against balanced budget amendments since they would result in actions that would worsen the phases of the business cycle.  They also feel the velocity of money is NOT stable.  Since velocity is unclear, monetary policy should be effective in offsetting changes in AD.

 

ECONOMIC GROWTH:  (Revisited from Ch 8)

Ø      The ­ in real GDP over time.

Ø      The ­ in real GDP per capita over time.  This is a better definition if you are looking at standard of living.

 

6 MAIN FACTORS of GROWTH:

1.  Quantity & Quality of Natural Resources.

2.  Quantity & Quality of Human Resources.

3.  Supply or Stock of Capital Goods.

4.  Technology.

5.  Aggregate Demand (must ­ for output to ­)

6.  Full Employment & Full Production of Resources.   This includes both allocative and productive efficiency.

 

GROWTH & PRODUCTION POSSIBLITIES ANAYLSIS:

Ø      Growth is shown by an outward shift of the PPC.

Ø      AD must ­ to remain at the full employment at each new production level.

Ø      New resources that cause the curve to shift outwards must be used efficiently in order to produce the maximum amount of output.

Ø      In addition, for the economy to obtain the highest possible increase in monetary value, the goods and services most wanted by society must be produced (allocative efficiency).

 

SUPPLY-SIDE of GROWTH:

Ø      Growth = Labor x Productivity

 

­ LABOR INPUTS depend on:

Ø      Size of Population.

Ø      Labor Force Participation Rate.

 

PRODUCTIVITY depends on:

Ø      Technological progress.

Ø      Availability of capital goods.

Ø      Quality of labor.

Ø      Efficiency.

 

* The extended AD-AS model can also be used to illustrate economic growth!  If potential output ­, LRAS will shift to the right.  In order to keep producing the maximum amount, AD must also increase.  The end result will be a little bit of inflation and real GDP growth.

 

 

PROBLEMS w/ GROWTH RECORD:

1.  Growth does NOT measure quality improvements.

2.  Growth does NOT measure increased leisure time.

3.  Growth does NOT take into account negative effects on the environment.

 

* Our growth rate has been around 3.1% per year since 1948, and our real GDP per capita has grown around 2% per year!

 

QUANTIFICATION of ECONOMIC GROWTH FACTORS:

Ø      More Labor (1/3 of total growth).

Ø      Better Technology (the MOST important factor … responsible for 26% of growth since 1929).

Ø      Quantity of Capital (responsible for 18% of growth since 1929).

Ø      Education & Training (improve quality of labor).

Ø      Improved Resource Allocation & Economies of Scale (responsible for about 12% of growth).

Ø      Other factors like the social cultural environment, political stability, positive work attitudes, and energetic immigrants also add to our growth, but are difficult to measure.

 

*** FASTER GROWTH W/O INFLATION IS POSSIBLE W/ HIGHER PRODUCTIVITY! ***

 

IS GROWTH DESIRABLE:  2 VIEWS

 

ANTIGROWTH VIEW:

Ø      Growth leads to pollution, global warming, ozone depletion, etc.

Ø      “MORE” does NOT always mean an improvement if it results in dead-end jobs and burnout.

Ø      High growth rates often cause high stress.

 

DEFENSE of GROWTH VIEW:

Ø      Improved standard of living.

Ø      Reduced poverty in poor countries.

Ø      Improved working conditions.

Ø      More leisure time.

Ø      Greater ability to deal with environmental problems.

 

GROWTH IS SUSTAINABLE:

Ø      Resource prices are NOT ­.

Ø      Today, growth is more so the result of applying knowledge and information.  Therefore, growth is only restricted by our imagination.

 

BUDGET DEFICIT:

Ø      The amount by which government’s expenditures exceed than its revenue during a given year.

Ø      G > T

 

BUDGET SURPLUS:

Ø      The amount by which government’s revenues exceed its expenditures during a given year.

Ø      T > G

 

NATIONAL (PUBLIC) DEBT:

Ø      The Federal government’s total deficits and surpluses that have accumulated over time.

 

*  State and local governments have typically run on a budget surplus!

 

3 BUDGET PHILOSOPHIES:

 

1.  ANNUALLY BALANCED BUDGET:  (Goal until the 1930s)

Ø      Procyclical … worsens the business cycle. 

Ø      In a recession, the government would be forced into ­ Taxes and ¯ Government Spending in order to keep the budget balanced because tax revenues would be less due to the lower income levels.

Ø      In an inflationary period, the government would be forced into ¯ Taxes and ­ Government Spending in order to keep the budget balanced because tax revenues would be greater due to the higher income levels.

Ø      Those who are for an annually balanced budget don’t want to restrict government’s growth.

 

2.  CYCLICALLY BALANCED BUDGET:

Ø      Lets the government somewhat stabilize the economy and control the length of the business cycle.

Ø      Deficit spending is permitted during a recession, and surpluses are allowed during an inflationary period.

Ø      The argument is often made that, over the course of the business cycle, deficits would be offset by surpluses (not realistic).

 

3.  FUNCTIONAL FINANCE:

Ø      A balanced budget is NOT the main goal of the government.

Ø      The main purpose of Federal finance is to achieve full employment without fluctuations in the price level.

Ø      The government should do whatever it takes to achieve this goal of non-inflationary full employment.

 

CAUSES OF ­ DEBT:

Ø      National Defense & Military Spending.

Ø      Recessions (¯ revenues and ­ government spending on programs to maintain incomes).

Ø      Tax cuts w/o equivalent spending cuts.

 

4 MAIN OPTIONS for BUDGET SURPLUSES:

Ø      Pay off part of the debt (This would also reduce our interest payments).

Ø      Reduce taxes (Limits the size of gov’t and returns $ back to those who earned it).

Ø      Increase government spending (Medicare drug coverage could use help)!

Ø      Add $ to the Social Security trust fund (More $ will be needed as the population ages).

 

DEBT & THE U.S. TRADE DEFICIT:

Ø      ­ interest rates may result from ­ demand for loanable funds (since the government will be borrowing more to finance its deficit.

Ø      As interest rates ­, the $ appreciates because foreigners demand more $ so that they can invest in U.S. securities.

Ø      This causes American goods to become more expensive to foreigners and foreign goods to become less costly to Americans.

Ø      The result of this is a trade deficit (imports > exports).

Ø      And, the Net Export Effect (Xn) will be negative (thereby slowing economic growth)!

 

 

 

 

 

*** The information above can be credited to the following sources ***

1.  Dr. Sharon Erenburg – Economics Professor – Eastern Michigan University

2.  Stanley L. Brue and Campbell R. McConnell, Economics, 15th Edition, (McGraw-Hill/Irwin) 2002.

3. Joyce Gleason and Janet West, Instructor’s Resource Manual (to accompany Economics, 15th Edition), McGraw-Hill/Irwin, 2002.