ADAS and Phillips Curve

AD/SRAS overview

• Aggregate Demand– Total spending on goods and services in the economy.– A change in C, I, G, or Xn causes a change in AD– PL and output (y) are changed by a change in AD

• Short Run Aggregate Supply– Total amount of goods and services produced in the

economy.– A change in input prices, productivity and government

policies change SRAS– PL and output(y) are changed when SRAS changes.

Economic Conditions

Price Level

LRAS

SRAS

AD

YF

PL

AD/AS at Full Employment

Price Level

LRAS

SRAS

AD

YF

PL

AD/AS in Recession

Y1

Price Level

LRAS

SRAS

AD

YF

PL

AD/AS with high inflation

Y1

GDPR

GDPRGDPR

GDPR

Price Level

LRASSRAS

AD

YF

PL

AD/AS with Stagflation

Y1

Changes in AD/SRAS… You tell me what changes and what happens to PL and output

• The government spends money national defense

• The price of oil rises

• There is a fall in consumer confidence

• Argentina buys more of US made goods

• The government increases regulation

• Interest rates increase

• Wages decrease

• Expansionary monetary policy

• The government gives subsidies to businesses

↑ AD, ↑ PL, ↑Y

↓ SRAS, ↑ PL, ↓ Y

↓ AD, ↓ PL, ↓Y

↑ AD, ↑ PL, ↑Y

↓ SRAS, ↑ PL, ↓ Y

↓ AD, ↓ PL, ↓Y

↑ SRAS, ↓PL, ↑ Y

↑ Sm, ↑ irN , ↑ AD, ↑ PL, ↑Y

↑ SRAS, ↓PL, ↑ Y

LRASPL

GDPR

SRAS

AD1

YF

PL1

PL2

LRASPL

GDPR

SRAS

AD1

YF Y2

PL2

PL1

AD2

Y2

AD2

AD ____ PL ____ Unemployment AD ____ PL ____ Unemployment

Between PL and Unemployment: (in the short run)

Click the mouse once to fill in the blanks.

• In the short run there is a TRADE-OFF between INFLATION and UNEMPLOYMENT.

– To reduce unemployment – inflation occurs– To reduce inflation --- unemployment increases

• Research by a Kiwi (New Zealand) economist named Williams Phillips documented this relationship in 1958 by studying the UK from 1861-1958 . As a result a new model was developed to illustrate the trade-off:

InflationRate

UnemploymentRate

SRPC

Inflation rate unemployment rate

%1

%2

U1 U2

InflationRate

UnemploymentRate

SRPC

%2

%1

U2 U1

Inflation rate ↓ unemployment rate

Due to the trade-off (inverse relationship), what is the shape of the SRPC?

Address the problem without creating a worse problem – limit the negative effects.

• When stagflation first occurred in the 1970s due to a supply-side shock ( price of oil/energy), it created a new dilemma for policymakers and called into question the credibility of the short run Phillips Curve (SRPC) relationship.

PL

GDPR

LRAS SRAS2

AD

YF

PL2

PL1

Y2

SRAS1

SRAS ____ PL ____ Unemployment

Does stagflation negate the SRPC trade-off between inflation and unemployment?

Some economists rejected the SRPC relationship; others found an alternative explanation.

It appears to negate the inverserelationship. Both PL and unemployment increase!

InflationRate

UnemploymentRate

SRPC1

%2

U

InflationRate

UnemploymentRate

SRPC1

%

U2

SRPC2SRPC2

Stagflation simply caused the SRPC to shift to the right --- indicating that foreach level of unemployment, there is a higher rate of inflation; for each inflation rate, there is a higher level of unemployment.

%1

U1

InflationRate

UnemploymentRate

SRPC2

%2

U

SRPC1

PL

GDPR

LRAS

SRAS2

AD

YF

PL1

PL2

Y2

SRAS1

SRAS ____ PL ____ Unemployment

For each level of inflation,a lower level of unemploy-ment exists.

For each level of unemployment,a lower level of inflation exists.

%1

Increase in AD → movement along Phillips Curve

Price Level

LRAS

SRAS

AD

YF

PL

GDPR

A

InflationRate

UnemploymentRate

LRPC

SRPC

A%A

NRU

B B%B

NRU

PL2

AD2

Shift in SRAS→ Shift in SRPC

Price Level

LRAS

SRAS

AD

YF

PL

GDPR

A

InflationRate

UnemploymentRate

LRPC

SRPC

A%A

NRU

B%BPL2 B

SRAS2

SRPC2

Practice Problems

• A short Run Phillips Curve shows an inverse relationship betweena) Interest rates and borrowingb) Inflation and unemploymentc) Income and consumptiond) Prices and quantity demandede) Inputs and outputs

Practice Problems

• Stagflation is most likely to be caused bya) An increase in ADb) A decrease in ADc) An increase in ASd) A decrease in ASe) A large increase in the money supply

Practice Problems

• An increase in personal income taxes will most likely cause AD and AS to change in which of the following ways in the short run?

AD ASa) Not change Decreaseb) Not change Increasec) Decrease Not Changed) Decrease Increasee) Increase Not Change

Practice Problems

• When firms restructure their operations to decrease production cost, the AS, PL and real output will change in which of the following ways?

AS PL Outputa) Shift left Increase Increaseb) Shift left Increase No Changec) Shift right Increase Increased) Shift right Decrease Increasee) Shift right Decrease Decrease

Practice Problems

• When an economy is at full employment, which of the following will most likely create demand pull inflation in the short run?

a) Increase in the discount rateb) An increase in personal income taxesc) A decrease in the real rate of interestd) A decrease in government spendinge) A decrease in the money supply

Practice Problems

• An increase in AD will cause which of the following?a) A movement along a given SRPCb) The LRPC to become horizontalc) An increase in the natural rate of unemploymentd) A decrease in the capital stocke) A decrease in the expected price level

Practice Problems

• Which of the following would cause the SRAS to shift to the right?a) An increase in the age rateb) An increase in the interest ratec) An increase in the natural rate of unemploymentd) A decrease in capital stocke) A decrease in the expected price level

Assume that the United States economy is currently in a recession in a short-run equilibrium. A. Draw a correctly labeled graph of the short-run and long-run Phillips curves. Use the letter

A to label a point that could represent the current state of the economy in recession. B. (b) Draw a correctly labeled graph of aggregate demand and aggregate supply in the

recession and show each of the following. i. The long-run equilibrium output, labeled Yfii. The current equilibrium output and price levels, labeled Ye and PLe, respectively

C. To balance the federal budget, suppose that the government decides to raise income taxes while maintaining the current level of government spending. On the graph drawn in part (b), show the effect of the increase in taxes. Label the new equilibrium output and price levels Y2 and PL2, respectively.

D. Assume that the Federal Reserve uses monetary policy to stimulate the economy. i. What open-market policy should the Federal Reserve implement? ii. Using a correctly labeled graph of the money market, show how the policy in part (d)(i) affects

nominal interest rates. iii. What will be the impact of the policy on the price level? Explain.

E. Now assume instead that the government and the Federal Reserve take no policy action in response to the recession.

i. In the long run, will the short-run aggregate supply increase, decrease, or remain unchanged? Explain.

ii. In the long run, what will happen to the natural rate of unemployment?

The unemployment rate in the country of Southland is greater than the natural rate of unemployment.

A. Using a correctly labeled graph of aggregate demand and aggregate supply, show the current equilibrium real gross domestic product, labeled YC, and price level in Southland, labeled PLC.

The president of Southland is receiving advice from two economic advisers—Kohelis and Raymond—about how best to reduce unemployment in Southland.

B. Kohelis advises the president to decrease personal income taxes. i. How would such a decrease in taxes affect aggregate demand? Explain. ii. Using a correctly labeled graph of the short-run Phillips curve, show the effect of

the decrease in taxes. Label the initial equilibrium from part (a) as point A, and the new equilibrium resulting from the decrease in taxes as point B.

C. Raymond advises the president to take no policy action. i. What will happen to the short-run aggregate supply curve in the long run?

Explain. ii. Using a new correctly labeled graph of the short-run Phillips curve, show the

effect of the change in the short-run aggregate supply you identified in part (c)(i).

• Assume that a country’s economy is in equilibrium.A. Using a correctly labeled ADAS graph, show how an increase in

the price of oil, an important resource will affect the price level and output in the short run.

B. Using a correctly labeled graph, who how the increase in the price of oil affects the short run phillips curve.

C. Assume that the central bank responds to the higher price of oil by increasing the money supply.

i. Explain the process by which the increase in the money supply will affect the AD in the short run.

ii. Indicate how the increase in the money supply will affect real output and price level.

D. Now assume instead of using monetary policy in response to the oil price increase, the government reduces business taxes, which result in lower production cost. Using a new correctly labeled graph, who the effect of the reduction in business taxes on the PL and output in the short run.