Unit 5 and 6 (revised)

Unit 5 and 6

Long Run and Short Run Curves

• AS curve doesn’t shift in response to changes in the AD curve in the short run.
• 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 price level
• When changes occur in the short run they result in either increased or decreased producer profits – not changes in wages paid.
• Nominal wages – money getting paid, Real wages – actual value of money, actual gross pay

1. 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.
2. 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 & no one is enticed (tempt) into or out of the market.
3. Demand-pull inflation will result when an increase in demand shifts the AD curve to the right, temporarily increasing output while raising prices.
4. 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 is not in response to the increase in AD, but instead the cause of price level increasing.

Philips Curve

The Philips Curve

• represents the relationship between unemployment and inflation
• The trade-off between the inflation and the unemployment occurs in the short run
• Each point on the Philips curve corresponds to a different level of output

Long Run Philips Curve

• It occurs at the Natural Rate of Unemployment (NRU)
• It is represented by a vertical line
• There is no trade-off between unemployment and inflation in the long run
• The economy produces at the full-employment output level
• The nominal wages of workers fully incorporate any changes in price level as wages adjust to inflation over the long run.

Determinants of the Philips Curve

Increase in AD = Up/left movement along SRPC
Determinants (increase): AD to the right, GDPR up & PL down: u% down & π% up: up/left along the curve

Decrease in AD = Down/right movement along SRPC
Determinants (decrease): AD to the left, GDPR up & PL down: u% up & π% down: down/right along the curve

SRAS down = SRPC to the left
Determinants (Inflationary Expectations, Input Prices, Productivity, Business Taxes, and/or Deregulation) (decrease): SRAS to the right, GDPR up & PL up: u% down & π% down: SRPC to the left

Supply shock - a rapid and significant increase in resource cost which causes the SRAS curve to shift
Natural Rate of Unemployment (NRU) = frictional + structural + seasonal

• The natural rate at fewer worker benefits creates a lower NRU

Misery Index – the combination of inflation and unemployment in any given year

• Single digit misery is good

If the inflation rate persists and the expected rate of inflation rises, then the entire SRPC moves upward. If inflation expectations drop (new technology, efficiencies), then the SRPC moves downward. Stagflation occurs when you have high unemployment and high inflation at the same time.
Disinflation – when inflation decreases over time:

1. Nominal
2. Business profits fall
3. Firms reduce employment, thus unemployment increases

Laffer Curve – trade-off between tax rates and government revenue; As tax rates increase from 0, tax revenues increase from 0 to some maximum level and then decline.

The higher the tax rate you set, the less money you will collect. Laffer Curve is controversial and debatable.

Criticisms on the Laffer Curve

1.      Where the economy is 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, save, and invest are small

Supply-side economics or Reaganomics

They support policies that support GDP growth by arguing that high marginal tax rates along with the current system of transfer payments (unemployment compensation and social security) provide disincentives to work, invest, innovative, and undertake entrepreneurial ventures. They believe that the AS curve will determine levels of inflation, unemployment, and economic growth.

Trickle-down effect: Rich → Poor
Marginal Tax-Rate: The amount paid on the last dollar earned or on each additional dollar earned.

Supply-side economists believe that if you reduce the marginal tax rate then more people will be able to work longer thus forgoing leisure time.


Edit: Added Trickle-down effect and marginal tax-rate.