Unit 5 Part 1

4/7/16

Extending the Analysis of Aggregate Supply

Short-Run Aggregate Supply:

·         Period in which wages (and other input prices) remain fixed as price level increases or decreases

*wages are constant; prices fluctuate*

Long-Run Aggregate Supply:

·         period of time in which wages have become fully responsible to changes in price level

*vertical line at full employment*

Effects over SR

·         price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant

·         In long-run, wages will adjust to price level and precious output levels will adjust accordingly

Equilibrium in the Extended Model

·         The long AS curve is represented with a vertical line at full employment level of real GDP

Demand Pull Inflation in AS Model

►   Demand-Pull: prices increase based on increase in aggregate demand

►   In the short-run, demand pull will drive up prices, and increase production

►   In the long-run, increases in aggregate demand will eventually return to previous levels

Cost Push & the Extended Model

►   Cost-push arises from factors that will increase per unit costs such as increase in the price of a key resource

Dilemma for the Government

►   In an effort to fight cost-push, the government can react in two different ways

►   Action such as spending by the government could begin as inflationary spiral

►   No action however could lead to recession by keeping production and employment levels declining

                                                                                                                                                               4/8/16

The Phillips Curve

Long-Run Phillips Curve

Note: Natural rate of unemployment is held constant

v  Because the LRPC exists at the natural rate of unemployment (Un), structural changes in the economy that affect Un will also cause the LRPC to shift

v  Increases in Un will shift LRPC à

v  Decrease in Un will shift LRPC ß

Short-Run Phillips Curve

►   There is a tradeoff between inflation and unemployment

Inflation ▲ Unemployment ▼

Inflation ▼ Unemployment ▲

Long Run Phillips Curve

►   There is NO tradeoff between inflation and unemployment

►   It is represented by a vertical line

►   It occurs at the natural rate of unemployment

►   LRPC will only shift if LRAS shifts

NRU= Frictional + Structural + Seasonal Unemployment

Standard Unemployment Rate à 4% to 5%

Major LRPC assumption: is that more worker benefits create higher rates and fewer worker benefits create lower rates

Supply Shocks: caused by rapid, and significant increases in resource cost, which causes the SRAS curve to shift

Misery Index: combination of unemployment and inflation in a given year; single digit misery is good