Stocks_and_Bonds

Chapter 16: Extending the Analysis of Aggregate Supply From Short Run to Long Run * Short-run: a period in which nominal wages (and other input prices) do not respond to price level changes. * Workers may not be fully aware of the change in their real wages due to inflation (or deflation) and thus have not adjusted their labor supply decisions and wage demands accordingly. * Employees hired under fixed wage contracts must wait to renegotiate regardless of changes in the price level. * Long-run: a period in which nominal wages are fully responsive to previous changes in price level * Short-run aggregate supply curve: three assumptions: * The initial price level is given at P1. * Nominal wages have been established on the expectation that this specific price level will persist. * The price level is flexible both upward and downward. * If the price level rises, higher product prices with constant wages will bring higher profits and increased output. * If the price level falls, lower product price with constant wages will bring lower profits and decreased output. Applying the Extended AD-AS Model * Demand-pull inflation: In the short run it drives up the price level and increases real output; in the long run, only price level rises. * Cost push inflation arises from factors that increase the cost of production at each price level; the increase in the price of a key resource, for example. This shifts the short run supply to the left, not as a response to a price level increase, but as its initiating cause. Cost-push inflation creates a dilemma for policymakers. * If government attempts to maintain full employment when there is cost-push inflation an inflationary spiral may occur. * If government takes a hands-off approach to cost push inflation, a recession will occur.The recession may eventually undo the initial rise in per unit production costs, but in the meantime unemployment and loss of real output will occur. * Recession and the extended AD-AS model. * When aggregate demand shifts leftward a recession occurs.If prices and wages are downwardly flexible, the price level falls.The decline in the price level reduces nominal wages, which then eventually shifts the aggregate supply curve to the right.The price level declines and output returns to the full employment level.   The Inflation-Unemployment Tradeoff * Both low inflation and low unemployment are major goals * The Phillips : between unemployment and wage inflation. * The basic idea is that given the short run aggregate supply curve, an increase in aggregate demand will cause the price level to increase and real output to expand, and the reverse for a decrease in AD. * This tradeoff between output and inflation does not occur over long time periods. * Great Depression * In the 1970s the economy experienced increasing inflation and rising unemployment: stagflation. * Adverse aggregate supply shocks-the stagflation of the 1970s and early 1980s may have been caused by a series of adverse aggregate supply shocks.(Rapid and significant increases in resource costs.) * The most significant of these supply shocks was a quadrupling of oil prices by the Organization of Petroleum Exporting Countries (OPEC). * Other factors included agricultural shortfalls, a greatly depreciated dollar, wage increases and declining productivity. * Leftward shifts of the short run aggregate supply curve make a difference.The Phillips Curve trade off is derived from shifting the aggregate demand curve along a stable short- run aggregate supply curve. * The "Great Stagflation" of the 1970s made it clear that the Phillips Curve did not represent a stable inflation/unemployment relationship. * Stagflation's Demise * tight money policy, reduced double-digit inflation and raised the unemployment * With so many workers unemployed, wage increases were smaller and in some cases reduced wages were accepted. * Firms restrained their price increases to try to retain their relative shares of diminished markets. * Foreign competition throughout this period held down wages and price hikes. * Deregulation of the airline and trucking industries also resulted in wage and price reductions. * A significant decline in OPEC's monopoly power produced a stunning fall in the price of oil. Long-Run Vertical Phillips Curve * This view is that the economy is generally stable at its natural rate of unemployment (or full-employment rate of output). * The hypothesis questions the existence of a long-run inverse relationship between the rate of unemployment and the rate of inflation. * In the short run we assume that people form their expectations of future inflation on the basis of previous and present rates of inflation and only gradually change their expectations and wage demands. * Fully anticipated inflation by labor in the nominal wage demands of workers generates a vertical Phillips Curve. Taxation and Aggregate Supply * Economic disturbances can be generated on the supply side, as well as on the demand side of the economy. Certain government policies may reduce the growth of aggregate supply."Supply-side" economists advocate policies that promote output growth.They argue that: * The U.S. tax transfer system has negatively affected incentives to work, invest, innovate and assume entrepreneurial risks. * To induce more work government should reduce marginal tax rates on earned income. * Unemployment compensation and welfare programs have made job loss less of an economic crisis for some people. Many transfer programs are structured to discourage work. * The rewards for saving and investing have also been reduced by high marginal tax rates. A critical determinant of investment spending is the expected after-tax return. * Lower marginal tax rates may encourage more people to enter the labor force and to work longer. The lower rates should reduce periods of unemployment and raise capital investment, which increases worker productivity. Aggregate supply will expand and keep inflation low. * There is empirical evidence that the impact on incentives to work, save and invest are small. * Tax cuts also increase demand, which can fuel inflation. Demand impact exceeds supply impact. * The Laffer Curve is based on a logical premise, but where the economy is located is an empirical question and difficult to determine. It may be hard to know in advance the impact of a tax cut on supply.