UNIT 5 & 6

Chapter 5: Extending the Analysis of Aggregate Supply

4/7/16

Short Run Aggregate Supply:

• The period in which wages (and other input prices) remain fixed as price level increases or decreases. 

Long Run Aggregate Supply:  

• The period of time in which wages have become fully responsive to changes in price level. 

Effects over Short Run:

• In the short run, price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant. 
• In the long run, wages will adjust to the price level & previous output levels will adjust accordingly. 

Equilibrium in the Extended Model:

• The extended model means the inclusion of both the short run and long run AS curves. 
• The long AS curve is represented with a 

Demand Pull Inflation in the AS Model: 

• Demand-Pull: Prices increase based on increase in aggregate demand.
• In the short run, demand pull will drive up prices, and increase productivity. 
• In the long run, increase 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.
• Short run shifts left. 

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 an inflationary spiral,
• No action however could lead to recession by keeping production and employment levels declining. 

4/8/16

The Long-Run Phillips Curve (LRPC): 

• There is NO trade off between inflation and unemployment in the Long-Run. 
• Occurs at natural rate of unemployment.
• It is represented by a vertical line
• Will shift if the LRAs curve shifts
• The Natural rate of unemployment is equal to: Formula: Frictional + Structural + seasonal unemployment       (4-5%)
• The major LRPC assumption is that more worker benefits create higher natural rates and fewer worker benefits create lower natural rates. 

• NOTE: Natural rate of unemployment is held constant
• Because the Long-Run Phillips Curve exists at the natural rate of unemployment (Un), structural changes in the economy that affect UN will also cause the LRPC to shift. 
• Increases in Un will shift LRPC --->
• Decreases in Un will shift LRPc <---

The Short-Run Phillips Curve (SRPC):
There is a trade off between inflation and unemployment
When one goes up, the other goes down. 

Supply Shocks:

• It is a rapid and significant increase in resources which causes the SRAs curve to shift.
• Decrease in SRAS: shift to the left --->
• SRPC will shift to the right <---

Misery Index:

• It is the communication of inflation and unemployment in any given year.
• Single-digit misery is good.
• If unemployment rate is 3% and inflation rate is 1%, it is good. 

4/11/16

Inflation:

• General rise in the Price Level.

Deflation:

• General decline in the Price Level.

Disinflation:

• Decrease in the rate of inflation over time.

Stagflation:

• Where unemployment & inflation increase at the same time. 

4/13/16

Supply-Side Economics:

• Shows changes in AS and not in AD, which determines the level of inflation, unemployment rates, and economic growth.
• Supply-side economists support policies that promote GDP growth by arguing that high marginal tax rates along with current system of transfer payments, unemployment compensation, or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures.
• Low marginal tax rates induce more work thus AS increases.
• Lower marginal tax rates also make leisure more expensive and more attractive.

Incentive to Save:

1. High Marginal Tax Rates:
         - Reduce the rewards for savings & investments.
2. Consumption:
         - Might increase, but investments depend upon saving.
3. Lower Marginal Tax Rates:

         - Encourage saving and investing. 

Laffer Curve:

• It is a theoretical relationship between tax rates and government revenue
• As tax rates increase by 0, tax revenues increase by 0 to a maximum level, then decline. 

Criticisms: 
  #1: Research suggests that the impact of the tax rates on incentives to work, save and invest are small.
  #2: Tax cut also increase demand, which can fuel inflation and demand may exceed supply. 
  #3: Where the economy is actually located on the curve, is difficult to determine. 

Chapter 6: Economic Growth & Productivity 

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 --> Populist policies
• Restrictions on Free International Trade