Unemployment Rate

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

808182 838485868788 8990919293 9495969798 990001020304 0506070809 10111213

(Perc

en

t)

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

RecessionUnemployment

Underemployment (U-6)Natural Rate of Unemployment (NAIRU)

Source: Department of Labor.

Labor Force Participation RateEmployment-to-Population

Vs Debt-to-GDP

55

56

57

58

59

60

61

62

63

64

65

66

67

68

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

(Perc

en

t)

25

30

35

40

45

50

55

60

65

70

75

RecessionEmployment Ratio Target = 62.5%Employment-to-Population (LHS)Labor Force Participation Rate (LHS)Debt-to-GDP (RHS)

Source: Department of Labor.

Aggregate Supply Curve – relationship between the quantity of output supplied and the inflation rate.

If prices and wages take time to adjust to their long-run level, the aggregate supply curve differs in the short run and long run.

Long Run Aggregate Supply Curve (LRAS) – denotes the amount of output that can be produced by the economy in the long run (Potential Output). Potential output is determined by:

1. Amount of capital in the economy2. Total amount of labor supplied at full employment3. Available technology that puts labor and capital together to produce goods and

services, G/S.

Natural Rate of Output (Potential Output) is the level of output produced at the Natural Rate of Unemployment (where the unemployment rate gravitates to in the long run). This is where the economy settles in the long-run for any inflation rate, P/P.

Chapter 22: Aggregate Supply Analysis

LRAS1

PL

Labor

L1FE

L2FE

AD/AS Model

LRAS2

PF1PF2

YY1

Pot Y2Pot

In the LR, YPot = f( # of workers K stock Technology) not PL

Shifts in Long Run Aggregate Supply (LRAS) CurveA. The 3 factors listed below grow fairly steadily over time, so potential

output increases over time. To simplify matters, when YP is growing steadily over time we represent YP as fixed.

1. Amount of capital in the economy2. Total amount of labor supplied at full employment3. Available technology that puts labor and capital together to produce

G/S.

in the Natural Rate of UnemploymentIf Natural Rate of Unemployment falls (ex. 4.5%) (labor is more heavily

utilized) => YP

If Natural Rate of Unemployment rises (ex. 6%) (due to retiring baby boomers) => YP (slows down the natural rate of output growth, 3% to 2.5%)

Shifts in LRAS

P/P = (P/P)et+1 + [Y – YP] –

where

(P/P)et+1 = Expected future inflation. Inflation, P/P, will rise one-for-one with increase

in (P/P)et+1.

Workers and firms care about real wages (w/P = x = amount of G/S wages can buy). If workers expect higher inflation in the future, they will demand higher wages to maintain real wages. Because labor costs typically makeup 70% of a firms costs, businesses will increase prices to maintain profit margins.

[Y – YP] = output gap is the difference between aggregate output and potential output.

= sensitivity of P/P to the output gap. > 0 creating an upward sloping SRAS curve. If [Y – YP] > 0, then there is little slack in the economy, labor markets get tight, workers

demand higher wages, and firms take opportunity to increase prices => higher P/PIf [Y – YP] < 0, then there is lots of slack in the economy, workers accept smaller increases

in wages, and firms need to lower prices to sell their goods => lower P/P

= Price (Supply) Shocks – occur when there is a shock to the supply of G/S produced in the economy.

Examples: Oil supply restrictions, developing countries rising demand for commodities, a falling exchange rate pushing up import prices, workers pushing for wage gains higher than productivity gains (Cost-push Inflation).

Short Run Aggregate Supply Curve

P/P = (P/P)et+1 + [Y – YP] –

SRAS curve implies that wages and prices are sticky in the short-run (the aggregate price level adjusts slowly over time). The more flexible wages and prices are, the more P/P responds to deviations of output, Y, from potential output, YP. This will increase the absolute value of and create a steeper curve. If wages and prices are completely flexible, then gets very large and the SRAS = LRAS.

Shifts in SRAS 1 (P/P)e

t+1 . (shifts curve up and to the left)2 Supply shock, (shifts curve up and to the left)

3. Persistent output gap, [Y – YP] => (P/P)et+1 .

If [Y – YP] > 0 is persistent, then the rise in P/P due to the movement along the SRAS curve, ( [Y – YP]) => (P/P)e

t+1 which shifts the SRAS curve up and back.

When [Y – YP] = 0 , then the SRAS stops shifting up because P/P and (P/P)et+1

stop rising. If [Y – YP] < 0 is persistent, then the fall in P/P due to the movement along the

SRAS curve, ( [Y – YP]) =>(P/P)et+1 which shifts the SRAS curve down

and to the right. Shifting stops when Y = YP

Short Run Aggregate Supply Curve

All markets are simultaneously in equilibrium – Quantity of aggregate output demanded is equal to quantity of aggregate output supplied.

Self-Correcting Mechanism – over time the short-run equilibrium moves/migrates to the long-run equilibrium. So if Y* = YP ,the short-run equilibrium, Y* will move over time to reach YP.

If the current level of P/P changes from its initial level, the SRAS curve will shift as wages and prices adjust to a new P/P)e

t+1. This shift over time will restore the economy to long-run equilibrium at full employment and YP.

General Equilibrium in the AD & AS Analysis

Consumer Price Index 1970 to Present

5.6

3.33.4

8.7

12.3

6.9

4.9

6.7

9.0

12.5

8.9

3.83.84.04.44.44.7

6.1

3.12.92.72.72.5

3.3

1.71.6

2.6

3.4

1.6

2.41.9

3.33.5

2.5

4.1

-0.1

2.8

1.4

3.0

1.7

3.8

1.1

13.3

2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5 2 .5

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Annual Percentage Change

10

GDP Output Gap vs.Inflation (CPI)

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

85 88 91 94 97 00 03 06 09 12

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

RecessionOutput GapHeadline Inflation2% Inflation Target

Source: CBO & Federal Reserve.

11

Nominal Interest Rates, Real Interest Rates and Inflation Expectations

-1

0

1

2

3

4

5

6

07 08 09 10 11 12 13

Source: Federal Reserve

-1

0

1

2

3

4

5

6

Inflation Expectations 10-yr Treas TIPS (10-Yr)

12

Oil Prices vs Inflation (CPI)(year over year % growth)

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

Headline Inflation (LHS)

2% Inflation Target

West Texas Intermediate Oil Prices (RHS)

Import Prices (12-month Growth) Vs Exchange Rates Major Currency Index

Nominal & Real (1973 = 100)

-8

-6

-4

-2

0

2

4

6

8

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13Percen

t

60

65

70

75

80

85

90

95

100

105

110

115

120

Ind

ex

Import Prices (Excluding Petroleum)NominalReal

ePEU x ($/e) = $PMUS

Import Prices vs Inflation (CPI)(year over year % growth)

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

Headline Inflation (LHS)

2% Inflation Target

Import prices

Labor Productivity and Costs(Nonfarm Business)

(% chg from year ago)

2.3%

4.5%

3.6%

2.9%2.9%3.1%3.5%

6.1%

4.3%4.7%

3.1%

1.9%

3.2%

4.6%5.0%

4.2%3.7%

1.5%1.3%

2.2%

1.1%1.7%1.6%

1.1%1.5%

0.1%

0.8%

0.2%

0.9%

2.6%2.5%1.9%

1.6%

0.3%

-1.1%

-0.2%

1.2%

3.0%

5.3%

6.2%

4.4%

3.3%

2.5%

1.2%0.9%0.8%

0.5%

2.5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

00 01 02 03 04 05 06 07 08 09 10 11 12

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Productivity Unit Labor Costs Wages

Source: Bureau of Labor Statistics

Econ 330 Chapter 22 Homework

Due Friday, May 2

Chapter 22Questions & Applied Problems 8, 11, 13, 14, 21,

23, 24