Unit 5 and 6

Unit 5 and 6

AD/AS From Short Runt to Long Run

• AS curve doesn't shift in response to changes in the AD curve in the short run
• i.e. - Nominal Wages do not respond to price level changes
• workers may not realize impact of the changes or may be under contract
• Long run- Period in which nominal wages are fully responsive to previous changes in the price level
• When changes occur in the short run they result in either increased or decreased produce profits not changes wages
• In the long run increases in AD result in a higher price level, as in the short run, but as workers demand more money the AS curve shifts left to equate production at the original output level, but now at a higher price
• In the long run, the AS curve is vertical at the natural rate of unemployment(NRU), or full employment(FE) level of output. Everyone who wants a job has one and no one is enticed into or out of the market
• Demand-pull Inflation will result when an increase in the demand shifts the AD curve to the right temporarily increasing output while raising prices
• Cost-push Inflation results when an increase in input costs that shifts the AS curve to the left. In this case the price level increase in not in response to the increase in Ad, but instead the cause of price level increasing.

Phillips' Curve

• Represents the relationship between unemployment and inflation
• Trade off between inflation and unemployment only occurs in the short run
• Each point on PC corresponds to a different level of output
• LRPC- occurs at the natural rate of unemployment, vertical line there is no trade off between unemployment and inflation in the long run
• economy produces at the full employment output level
• Nominal wages of workers full incorporate any changes in PL as wages adjust to inflation over the long run
• LRPC will only shift if LRAS shifts
• Increases in unemployment shifts LRPC to the right
• Decreases in unemployment shifts LRPC to the left

Types of Unemployment

1. Frictional
2. Structural
3. Seasonal

Short run Phillips curve

• PC stable in short run, because SRAS curve is stable

Supply Shock

• Rapid and significant increases in resource costs which causes the SRAS curve to shift thus producing a corresponding shift in the SRPC curve.

Misery Index

• combo of inflation and unemployment in any given year
• single digit misery is good

Stagflation

• occurs when you have high unemployment and high inflation occurring at the same time

Disinflation

• when inflation decreases overtime

Supply-side economics (Reaganomics)

• Support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transferred payments such as unemployment and social security payments provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures.
• Economists tend to believe that the AS curve shifts to the right thus creating the trickle-down effect.

Marginal tax rates

• amount paid on last dollar earned or on each additional dollar earned
• by reducing the marginal tax rates supply-siders believe that you will encourage more people to work longer foregoing leisure time for extra income

Laffer Curve

• trade offs between tax rates and tax revenues
• Criticisms
1. Where the economy is actually located on the curve is difficult to determine.
2. Tax cuts also increase demand, which can fuel inflation.
3. Empirical evidence suggests that the impact of tax rates on incentives to work, invest, and save are small.
• The higher the tax rate you set, the less money you will collect.
• Laffer curve is controversial and debatable.

Economic Growth Defined

•          Sustained increase in Real GDP over time.

•          Sustained increase in Real GDP per Capita over time.

Why Grow?

•          Growth leads to greater prosperity for society.

•          Lessens the burden of scarcity.

•          Increases the general level of well-being.

Conditions for Growth

•          Rule of Law

•          Sound Legal and Economic Institutions

•          Economic Freedom

•          Respect for Private Property

•          Political & Economic Stability

–        Low Inflationary Expectations

•          Willingness to sacrifice current consumption in order to grow

•          Saving

•          Trade

Physical Capital

•          Tools, machinery, factories, infrastructure

•          Physical Capital is the product of Investment.

•          Investment is sensitive to interest rates and expected rates of return.

•          It takes capital to make capital.

•          Capital must be maintained.

Technology & Productivity

•          Research and development, innovation and invention yield increases in available technology.

•          More technology in the hands of workers increases productivity.

•          Productivity is output per worker.

•          More Productivity = Economic Growth.

Human Capital

•          People are a country’s most important resource. Therefore human capital must be developed.

•          Education

•          Economic Freedom

•          The right to acquire private property

•          Incentives

•          Clean Water

•          Stable Food Supply

•          Access to technology

Hindrances to Growth

•          Economic and Political Instability

–        High inflationary expectations

•          Absence of the rule of law

•          Diminished Private Property Rights

•          Negative Incentives

–        The welfare state

•          Lack of Savings

•          Excess current consumption

•          Failure to maintain existing capital

•          Crowding Out of Investment

–        Government deficits & debt increasing long term interest rates!

•          Increased income inequality à Populist policies

•          Restrictions on Free International Trade

The Phillips Curve

•          In a 1958 paper, New Zealand born economist, A.W. Phillips published the results of his research on the historical relationship between the unemployment rate (u%) and the rate of inflation (π%) in Great Britain. His research indicated a stable inverse relationship between the u% and the π%. As u%↓, π%↑ ; and as u%↑, π%↓. The implication of this relationship was that policy makers could exploit the trade-off and reduce u% at the cost of increased π%. The Phillips curve was used as a rationale for the Keynesian aggregate demand policies of the mid-20^th century.

Trouble for the Phillips Curve

•          In the 1970’s the United States experienced concurrent high u% & π%, a condition known as stagflation. 1976 American Nobel Prize economist Milton Friedman saw stagflation as disproof of the stable Phillips Curve. Instead of a trade-off between u% & π%, Friedman and 2006 Nobel Prize recipient Edmund Phelps believed that the natural u% was independent of the π%. This independent relationship is now referred to as the Long-Run Phillips Curve. I believe it’s relevant that by this time the Bretton-Woods system had collapsed.

The Long-Run Phillips Curve (LRPC)

•          Because the Long-Run Phillips Curve exists at the natural rate of unemployment (u_n), structural changes in the economy that affect u_n will also cause the LRPC to shift.

•          Increases in u_n will shift LRPC à

•          Decreases in u_n will shift LRPC ß

The Short-Run Phillips Curve (SRPC)

•          Today many economists reject the concept of a stable Phillips curve, but accept that there may be a short-term trade-off between u% & π% given stable inflation expectations. Most believe that in the long-run u% & π% are independent at the natural rate of unemployment. Modern analysis shows that the SRPC may shift left or right. The key to understanding shifts in the Phillips curve is inflationary expectations!

Relating Phillips Curve to AS/AD

•          Changes in the AS/AD model can also be seen in the Phillips Curves

•          An easy way to understand how changes in the AS/AD model affect the Phillips Curve is to think of the two sets of graphs as mirror images.

•          NOTE: The 2 models are not equivalent. The AS/AD model is static, but the Phillips Curve includes change over time. Whereas AS/AD shows one time changes in the price-level as inflation or deflation, The Phillips curve illustrates continuous change in the price-level as either increased inflation or disinflation.

Summary

•          There is a short-run trade off between u% & π%. This is referred to as a short-run Phillips Curve (SRPC)

•          In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC)

•          The LRPC exists at the natural rate of unemployment (u_n).

–        u_n ↑ .: LRPC à

–        u_n ↓ .: LRPC ß

•          ΔC, ΔI_G, ΔG, and/or ΔX_N = Δ AD = Δ along SRPC

–        AD à .: GDP_R↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC

–        AD ß .: GDP_R↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

•          Δ Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC

–        SRAS à .: GDP_R↑ & PL↓ .: u%↓ & π%↓ .: SRPC ß

–        SRAS ß .: GDP_R↓ & PL ↑ .: u%↑ & π%↑.: SRPC à