Unit V & VI: AD/AS From Short Run to Long Run

 

• When changes occur in the short run they results in either increased or decreased producer profits – not changes in wages paid
• 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 join then has one and no one is enticed into or out of the market
• Demand-Pull inflation will result when an increase in 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 is not in response to the increase in AD, but instead the cause of the price level increasing
• 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 importance of the changes or may be under a contract
• Long Run – period in which nominal wages are fully responsive to price changes in price level
• Philips Curve
• Relationship between the unemployment and inflation
• Trade off between inflation and unemployment only occurs in the short run
• Each point on the Philips curve corresponds to a different level of output
• Long Run Phillips Curve (LRPC)
• It occurs at the natural rate of unemployment
• Represented by a vertical line
• There is no trade off unemployment and inflation in the long run
• The economy produces at the full employment output level
• The nominal wages of workers fully incorporate any change in price level as wages adjust to inflation over the long-run
• LRPC only shifts if LRAS shifts
• Increases in NRU will shift LRPC right
• Decreases in NRU will shift LRPC left
• If the NRU changes, causes LRPC to shift
• Three Types of Unemployment That Change NRU are:
• Frictional
• Structural
• Seasonal
• Short Run Phillips Curve (SRPC)
• PC is assumed to be stable in the short run, because the SRAS curve is assumed to be stable
• Increase in AD = up/left movement along SRPC
• Decrease in AD = down/right movement alon SRPC
• Supply Shock - rapid and significant increases in resource cost which causes the SRAS to shift thus producing a corresponding shift in the SRPC curve
• ex: price of oil
• Misery Index - a combination of inflation and unemployment in any given year
• Single digit misery is good
• Stagflation - when you have high unemployment and high inflation occurring at the same time
• Disinflation - when inflation decreases over time
• Supply-Side Economics/Reaganomics - they 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
• The supply-side economists tend to believe that AS curve shifts to the right thus creating the trickle down effect (rich to poor)
• Marginal Tax Rates - the amount paid on last dollar earned or on each additional dollar earned
• By reducing the marginal tax rate, supply-siders believe that you will encourage more people to work longer foregoing leisure for extra income
• Laffer Curve - tradeoffs between tax rates and tax revenues
 
• The higher the tax rate you set, less money you will collect
• Laffer curve is controversial and debatable
• 
• Three Criticisms of the Laffer Curve
• Where the economy is actually located on the curve is difficult to determine
• Tax cuts also increase demand which can fuel inflation
• Empirical evidence suggests that the impact of tax rates on incentives to work, invest, and save are small