Supply side of Equilibrium.pptx

8/14/2019 Supply side of Equilibrium.pptx

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Supply side of Equilibrium


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From the last chapter

The position of the AD Curve decides whether thecountry is experiencing a recessionary gap or ainflationary gap.

Too little of spending leads to recessionary gapwhereas too much leads to inflationary gap.

Shift in the Ad curve creates a multiplier effect

But in reality multiplier is less than what is

theoretically seenThere is a trade off between inflation andunemployment.


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Supply side analysis

Tells exactly where the economy is in equilibrium.

Does the market have an efficient self correctingmechanism?

Why there need not be a trade off betweenunemployment and inflation?

Explains the problem of stagflationthesimultaneous occurrence of high inflation and

high unemployment. When is the multiplier less effective than it is

theoretically seen.


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Aggregate supply curve


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The Aggregate supply curve

The relationship between the price level and

the quantity of real GDP supplied, holding all

other determinants of quantity supplied

constant is the aggregate supply curve.

Other factors like changes in wages,

production costs, technology, capital stock, etc

would make the aggregate supply curve shift.


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Wages are the major element of cost in theeconomy accounting for more than 70% of allinputs.

Higher wages or input costs would mean lowerprofits for entrepreneurs.

When profits squeeze firms decide to cut backproduction.

Thus wage increase or cost of productionincrease leads to leftward shift of the aggregatesupply curve.


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Technology and Productivity: The idea that

technological progress increases the

productivity of labour is familiar from earlier

chapters.

More Availability of capital would make the

aggregate supply curve to shift right


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Shift of the Aggregate Supply curve


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Equilibrium of the Real GDP and the

Price Level


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At any price level other than at point E there is

either an excess or a deficit of Aggregate

demand or supply.

Price level would restore the economy back to

equilibrium if left to itself at its own time.


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Equilibrium Price level


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Inflation and the multiplier

What happens to equilibrium GDP if the AD

curve shifts outward?

Such changes have a multiplier effect.

But in practice the actual numerical value is

much smaller than the multiplier.

Variable imports could be one of the reasons.

But largely inflation reduces the size of the

multiplier.


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As the multiplier process unfolds will firms meetthe additional demand without raising prices?

If the aggregate supply slopes upward the answeris no.

Thus there is increase in price when themultiplier process unfolds.

This will reduce spending to some extentdampening net exports and consumer spending.

As a consequence the multiplier effect is lesserthan it would have been in the absence ofinflation.


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Inflation reduces the multiplier effect


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Recessionary and Inflationary Gaps

revisited

Will equilibrium occur at below or potential GDP?

The answer to this question was not completelyavailable in the last chapter.

Depending on the locations of the aggregate demand

and supply curves we can reach equilibrium beyondpotential GDP,(Causing inflationary Gap) at potentialGDP or below potential GDP (Causing recessionarygap).

The following figures consider both the aggregatedemand and aggregate supply and therefore determineboth the equilibrium price level and the equilibriumGDP at point E.


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In the short run because wages are fixed any

one the three cases depicted in the last graphs

can occur.

In the long run wages will adjust to the labour

market conditions which will shift the

aggregate supply curve.


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Adjusting to recessionary gap

Recessionary gaps are created due to

insufficient spending or anaemic investment.

With equilibrium GDP below the potential

levels jobs become scarce.

Workers may lose the bargain for wages.

In extreme scenarios the supply curve shifts to

the right due to downfall in wages.


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Deflation is rare in modern world

History shows that in the US there were

several examples of deflation before the

second world war but there has been no

single case after that.

Japan seems to have experienced severe

stagflation in the last decade.


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Why nominal wages wont fall

Institutional factors such as minimum wages act.

Government regulations.

Workers have a profound psychological resistance to

downward movement in nominal wages though not forrise in wages when the real income falls.

The above factor is psychological in nature.

Firms may have the fear that they loose their

employees to competitors. Workers differ in productivity...You may only get the

bad ones if paid low... You get what you pay for


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The implications of this rigidity are quite serious.

When wages and prices will not fall recessionarygaps could stay for long period.

But how long would the unemployment persist. Eventually the need for employment would

overwhelm their resistance to wage cut.

The Economy would eventually lead from E to F ina painful way as shown in the next graph.

How long can a country afford to wait?


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Elimination of the recessionary gap


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Adjusting to inflationary gap

When the aggregate curve as shown in thenext graph is SoSo and the aggregate demandcurve is DD the economy is in an equilibrium

at point E. The inflationary gap is created to the extent

BE.

This would happen when the unemploymentrate dips below the natural rate ofunemployment.


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When equilibrium GDP exceeds the potential

GDP, jobs are plentiful and labour is in great

demand.

Rising nominal wages adds to business costs

which shifts the aggregate supply curve to the

left to S1S1.

Inflation eventually erodes the inflationary

gap.


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Inflation arises because buyers demand more

output than the economy can produce.

This leads to increase in price.

Rising prices cuts short the purchasing power

of consumers and would also lead to fall in

exports and rise in imports.

Economy would eventually move back along

the curve DD from point E to point F.


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This scenario is what some economists believed

had happened in 2006 and 2007.

US economy had inflationary gap in 2006 and

2007, they expected inflation to rise slightlywhich later started receding.

The self correcting mechanism takes time

because wages and prices do not adjust quickly. Policy interventions would speed up the process.


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Elimination of an Inflationary Gap


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Demand Inflation and stagflation

When the AD curve is very high it intersects

the AS curve at beyond full employment.

Usually Aggregate demand in excess of

potential GDP is seen as the root cause of

inflation in the analysis so far.

But this need not be the only cause of

inflation.


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Inflation may seen two dimensionally, demand

pull or cost push.

Rising wages is seen as one of the primary

reasons for inflation.

However rising wages and resulting increasing

prices are symptoms of increased aggregate

demand.


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As seen in the previous figure output falls while

prices rise as the economy adjusts from point E to

point F.

This turns out to be the first explanation of thephenomenon of stagflation.

So the period of stagflation is usually the part of

the normal aftermath of the period of excessiveaggregate demand.

This is stagflation caused by inflationary boom.


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Once the inflationary gap is eliminated due to rise

in prices the economy starts stagnating. Real GDP

growth will fall and will onset recession.

Yet inflation remains high through the earlymonths of recessions.

As discussed before the self correcting

mechanism would push the wages down andshift the supply curve to left. This however would

take a longer time for reasons discussed before.


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Stagflation from a supply shock

There are however many other reasons for stagflation.

When unemployment and inflation both soared in1970s and 1980s in the US the reason was not that ofan inflationary boom.

Steep rise in energy prices due to OPECs cut in

production quota was the cause.

1990 Iraq invasion of Kuwait pushed the prices again.

Energymost important of the inputs. High energy prices shifted the aggregate supply curve

inward.


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The typical results of an adverse supply shocks

are lower output and higher inflation.

It can happen due to any of the supply

reducing events. So stagflation is typically a

result of adverse supply shifts.


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Stagflation from an Adverse shift in

Aggregate Supply


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The Price Level and Real GDP Output in the

United States, 19722007


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The next diagram provides a more realisticversion of the aggregate supply and demanddiagram that illustrates how our theoretical

model applies to a growing economy. The Economy has moved from equilibrium

from point A to B.

So it is the amount of shifts in the aggregatedemand curve and aggregate supply curvethat decides.


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If fluctuations in the economys real growth

rate from year to year arise primarily from

variations in the rate at which the aggregate

demand increases, then there is likely to behigh inflation when output would grow more

rapidly


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Aggregate Supply and Demand

Analysis of a Growing Economy


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Effects of Faster growth of Aggregate

Demand


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Stagflation from an Adverse Supply

shock


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Effects of a Favourable supply shock


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The most favourable growth of the supply and

demand shifts is what is shown in the last

graph when they shift in the same proportion.

When the economys self correcting

mechanism works very slowly it seeks the

governments intervention to accomplish

stabilisation in much faster way.

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Supply side of Equilibrium.pptx