Aggregate Supply and Macroeconomic Policy

Aggregate Supply in the Short Run and in the Long Run

 Demand-Pull Inflation

Cost-Push Inflation

Recession and Aggregate Supply

The Phillips Curve

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Before we start our discussion of the aggregate supply curve let us recall the following important relationships.
 

• The shape and the position of demand for money reflecting the relationship between the interest rate and demand for money
• The relationship between the interest rate and investment
• The reaction of the price level to changes in the aggregate expenditures (and aggregate demand)
• The effect of the price level on wages and the prices of other resources

In the short run increases in the price level do not affect wages and prices of other resources. This could be because of information gaps or the structure of the relationships between workers and employers. Production adjustment are made under existing wage structures.

In the short run, the slope of the aggregate supply curve would depend on the reaction of labor (supply) to increased demand for labor by the employer. The employers may even succeed in attracting some of the structurally unemployed people to the job market (by offering them higher nominal wages), pushing the economy beyond its full-employment level of output.

In the long run, however, workers will likely discover that higher prices have reduced their real wages. Chances are that they demand higher nominal wages (or adjust their labor supply.) Higher wages (as well as higher prices of other resources) will shift the aggregate (short-run) supply to the left.

In the extended AD-AS model we allow for the AS curve to react to the possible changes in the price. In the long run we expect the equilibrium level of output to eventually settle at its full-employment level.

Demand-Pull Inflation
Assuming a upward-sloping short-run aggregate supply curve, an increase in aggregate demand (expenditures) will result in the higher prices. If higher prices cause wages to increase (in the long run), shift of the AS line to the left will off set the impact of the increased demand on the economy's output.

Cost-Push Inflation
An increase in the cost of production (resulting from an increase in the price of a input such as, say, energy) will shift the AS curve to the left, raising the price level and reducing the level of output.

What should the government do when faced with cost-push inflation (stagflation)?
Should it try to increase the aggregate demand (expenditures) through monetary or fiscal policy, or shout it do nothing and let the recession take its course?

An expansionary fiscal or monetary policy could result in an inflationary spiral.
Doing nothing could mean accepting  in a long period of unemployment.

Recession and Aggregate Supply
A recession could be caused by a drop in one of our aggregate expenditures (investment or exports, for example.) Such a decline in spending will shift aggregate demand to the left, resulting in lower prices and a lower level of output.

What do we do? Should we wait for wages and prices of other resources to react to the lower price level and hope that adjustments in wages and other resource prices would eventually bring the economy back to full employment?

The Phillips Curve
Given the shape of the short-run AS curve, shifts in the AD line will result in higher prices but also higher levels of output and employment. This tradeoff between inflation and unemployment has been studied by a number of economists including a British economist named Phillips.

The Phillips curve is negatively sloping line in a two-dimensional space with unemployment rate measured horizontally and an inflation measure depicted vertically.

Shifts of AS curve to the left, stagflation, could result in shifts of the Phillips curve to the right. That would indicate that maintaining the same level of employment would require accepting higher levels of inflation.

The Phillips curve and the recession of the early 1980s: Has the U.S. Phillips curve shifted to the left lately?
 

Natural-Rate Hypothesis
Is the (long-run) Phillips curve (PC) vertical?
If wages and prices are flexible, any increase in the aggregate demand will be met with higher prices and wages and, thus, will have  no effect on the real level of output and employment. This would make the Phillips curve vertical; a vertical line intercepting with the horizontal axis at the natural level of unemployment.

Supply-Side Economics
A shift of the aggregate supply curve to the right would not only result in a higher level of output (lower unemployment), it could also cause reductions in the price level. What could cause shifts in the aggregate supply curve?  Supply-side economists argue that lower tax rates which encourage more savings and investments along with deregulation ( relaxing environmental laws and other cost-increasing regulations) would do the job. If an increase in government spending is accompanied by a tax cut ( shifts of both aggregate supply curve and aggregate demand curve to the right,) its effect on the level of out put will be enhanced.