| 1. |
The aggregate supply curve has
short- and long-run characteristics. The short-run curve also shifts because of an
increase in nominal wages. These factors make the analysis of aggregate supply and demand
more complex.
- The short run is a period in which nominal wages
(and other input prices) remain fixed as the price level changes. The long run is a period
in which nominal wages are fully responsive to changes in the price level.
- The short-run aggregate supply curve is upward
sloping: An increase in the price level increases business revenues and profits because
nominal wages are fixed; in contrast
when the price level decreases
business revenue and
profits decline
and so does real output.
- The long-run aggregate supply curve is vertical
at the potential level of output. Increases in the price level will increase nominal wages
and cause a decrease (shift left) in the short-run aggregate supply curve
or declines in
the price level reduce nominal wages and increase (shift right) the short-run aggregate
supply curve. In either case
although the price level changes
output returns to its
potential level
and the long-run aggregate supply curve is vertical at the
full-employment level of output.
- Equilibrium in the extended AD-AS model occurs at
the price level and output where the aggregate demand crosses the long-run aggregate
supply curve and also crosses the short-run aggregate supply curve.
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| 2. |
The extended AD-AS model can be applied to
explain conditions of inflation and recession in an economy.
- Demand-pull inflation will increase (shift right)
the aggregate demand curve
which increases the price level and causes a temporary
increase in real output. In the long run
workers will realize that their real wages have
fallen and will demand raises in their nominal wages. The short-run aggregate supply
curve
which was based on fixed nominal wages
now decreases (shifts left)
resulting in
an even higher price level and with real output returning to its initial level.
- Cost-push inflation will decrease (shift left)
the short-run aggregate supply curve. This situation will increase the price level and
temporarily decrease real output
causing a recession. It creates a policy dilemma for
government.
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- If government takes actions to counter the
cost-push inflation and recession by increasing aggregate demand
the price level will
move to an even higher level
and the actions may set off an inflationary spiral.
- If government takes no action
the recession will
eventually reduce nominal wages
and eventually the short-run aggregate supply curve will
shift back to its original position.
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- If aggregate demand decreases
it will result in
a recession. If prices and wages are flexible downward
the price level will fall and
increase real wages. Eventually
nominal wages will fall to restore the original real
wages. This change will increase short-run aggregate supply and end the recession
but not
without a long period of high unemployment and lost output.
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| 3. |
The Phillips Curve is important for examining
the short- and long-run relationship between inflation and unemployment.
- If aggregate supply is constant and the economy
is operating in the upsloping range of aggregate supply
then the greater the rate of
increase in aggregate demand
the higher the rate of inflation (and output) and the lower
the rate of unemployment. This inverse relationship between the rate of inflation and
unemployment is known as the Phillips Curve.
- In the 1960s
economists thought there was a
predictable tradeoff between unemployment and inflation. All society had to do was to
choose the combination of inflation and unemployment on the Phillips Curve.
- Events of the 1970s and 1980s called into
question the stability of the Phillips Curve. In that period
the economy experienced both
higher rates of inflation and unemployment (stagflation). The data suggested that the
Phillips Curve had either shifted right or that there was no dependable tradeoff between
inflation and unemployment.
- The stagflation of the 1970s and early 1980s was
most likely caused by aggregate supply shocks from an increase in resource prices (oil)
shortages in agricultural production
higher wage demands
and declining productivity.
These shocks decreased the short-run aggregate supply curve
which increased the price
level and decreased output (and unemployment).
- The demise of stagflation came in the 1982 –
1989 period because of such factors as a severe recession in 1981 – 1982 that reduced
wage demands
increased foreign competition that restrained price increases
and a decline
in OPEC’s monopoly power. The short-run aggregate supply curve increased
and the
price level and unemployment rate fell. This meant that the Phillips Curve may have
shifted back (left). Recent unemployment-inflation data are now similar to the Phillips
Curve of the 1960s.
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| 4. |
The natural rate hypothesis questions the
existence of a downsloping Phillips Curve and views the economy as stable in the long run
at the natural rate of unemployment. There are two variants to this hypothesis.
- Adaptive expectations theory suggests that an
increase in aggregate demand sponsored by government may temporarily reduce unemployment
as the price level increases and profits expand
but the actions also set into motion
other events.
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- The increase in the price level reduces the real
wages of workers who demand and obtain higher nominal wages; these actions return
unemployment to its original level.
- Back at the original level
there is now a higher
actual and expected rate of inflation for the economy
so the short-run Phillips Curve has
shifted upward.
- The process is repeated when government tries
again to reduce unemployment
and the rise in the price level accelerates as the short-run
Phillips Curve shifts upward.
- In the long run
the Phillips Curve is stable
only as a vertical line at the natural rate of unemployment; there is no tradeoff between
unemployment and inflation.
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- Rational expectations theory (RET) assumes that
workers fully anticipate that government policies to reduce unemployment will also be
inflationary
and they increase their nominal wage demands to offset the expected
inflation; thus there will not even be a temporary decline in unemployment or even a
short-run Phillips Curve.
- The interpretations of the Phillips Curve have
changed over the past three decades based on the adaptive and rational expectations
analysis. This consensus view of economists is that there is a short-run tradeoff between
unemployment and inflation
but not a long-run tradeoff. Most economists also now
acknowledge that both aggregate supply shocks and misguided government policies
contributed to the stagflation of the 1970s.
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| 5. |
Supply-side economics views aggregate supply as
active rather than passive in explaining changes in the price level and unemployment.
- It argues that higher marginal tax rates and a
widespread system for public transfer payments reduce incentives to work and that high
taxes also reduce incentives to save and invest. These policies lead to a misallocation of
resources
less productivity
and a decrease in aggregate supply. To counter these
effects
supply-side economists call for a cut in marginal tax rates.
- The Laffer Curve suggests that it is possible to
lower tax rates and increase tax revenues
thus avoiding a budget deficit because the
policies will result in less tax evasion and reduced transfer payments.
- Critics of supply-side economics and the Laffer
Curve suggest that the policy of cutting tax rates will not work because
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- It has only a small and uncertain effect on
incentives to work (or on aggregate supply).
- It would increase aggregate demand relative to
aggregate supply and thus reinforce inflation when there is full employment.
- The expected tax revenues from tax rate cuts
depend on assumptions about the position on the Laffer Curve. If tax cuts reduce tax
revenues
it only contributes to problems with existing budget deficits.
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- Another tenet of supply-side economics is that
overregulation of the economy by government (both industrial and social regulation) has
decreased productivity
led to higher costs
and reduced economic growth.
- The economic program of the Reagan administration
(1981 – 1988)
or Reaganomics
was based on supply-side ideas. This program reduced
government regulation and cut personal and corporate income taxes.
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- The record shows that by the late 1980s
there
was a reduction in inflation and interest rates
an economic expansion
and the
achievement of full employment.
- The supply-side approach can also be criticized.
There is little evidence to show that the tax cuts increased aggregate supply beyond its
historic pace
or provided strong incentives to work
or increased saving or investment.
The economic expansion may also be attributed to the expansionary effect of the tax cuts
on aggregate demand. The tax cuts also increased U.S. budget deficits and were not
financed by increasing tax revenues as predicted by the Laffer Curve.
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