Macro Chapter 36 and 37

Criticisms of supply side and laffer curve

1. Cutting taxes only has a small and uncertain effect on incentives to work 2. Tax cuts increase aggregate demand more than aggregate supply which would just create more inflation. 3. It is hard to know where the economy actually is on the laffer curve, so we do not know how much to cut taxes or if it will actually help.

What three generalizations can be made on the relationship between inflation and unemployment in long run and short run?

1. In the short run, there is a trade off between the rate of inflation and the rate of unemployment 2. Shocks from aggregate supply can cause higher inflation and higher rates of unemployment. 3. In long run, there is no trade off between inflation and unemployment

Two policy approaches for cost push inflation

1. Increase aggregate demand, but also risk setting off inflation. 2. Take no action and wait for short run aggregate supply to return to its initial position, but remain in recession.

What can shift the short run phillips curve outward?

A change in Aggregate supply or a change in expected inflation. More expected inflation shifts it out and less expected inflation shifts it in. Increased aggregate supply shifts the curve inward and decreased aggregate supply shifts the curve outward.

A shift right in production possibilities is equal to . . .

A rightward shift in long run aggregate supply

Shocks in Aggregate Demand

A shock in aggregate demand is just a sudden increase in C, I, G, or Xn. It is usually investment that changes the most.

Effect of an increase in aggregate demand in the long run

Aggregate demand shifts to the right causing the price level to increase and reducing unemployment. Profits expand. An increase in the price level will cause workers to demand higher wages to meet this increase, shifting aggregate supply to the left. As a result, we are back at the original level but at higher rates of inflation. The short run phillips curve has shifted upward.

Efficiency wage

An efficiency wage minimizes the firm's labor cost per unit of output while still being higher than they market wage. The higher wage results in greater efficiency with greater work effort, less supervision costs, and reduced job turnover.

Phillips Curve

Assuming a constant aggregate supply curve (short run), this shows the inverse relationship between the rate of inflation and unemployment.

Short run aggregate supply

Curve is upsloping. Increase in price level increases outputs because input prices do not change. Decrease in price level lowers output too.

Long run aggregate supply

Curve is vertical at the potential level of output. Increase in price level will increase input prices and cause a decrease in short run aggregate supply. Opposite is true too with decrease. In both of these cases, the price level changes but the output eventually goes back to its original spot on the Long run curve.

Long run approach to recession

Decline in aggregate demand pushes down input prices, which eventually increases short run aggregate supply. This increases real output and restores full employment to end the recession.

Laffer Curve

Depicts the relationship between tax rates and tax revenues. It suggests that it is possible to have lower tax rates and increase tax revenues. This helps avoid a budget deficit because it will result in less tax evasion and tax avoidance. Lower tax rates also stimulate working, saving, investing, innovating, and accepting business risks which will lead to more income and more tax revenue.

Monetarist view on instability

Economic instability is a result of inappropriate monetary policy. They believe that changes in the money supply create instability

Ongoing inflation

Fed uses monetary policy to increase AD faster than the supply factors of growth shift the long run AS curve to the right. This causes ongoing inflation.

Mainstream View of Self correction

Prices and wages are inflexible downward. This means that a decrease in aggregate demand will cause the curve to shift left but not down. It will decrease output without changing the price level because the price level is downwardly inflexible. Inflexibility downward is caused by wage contracts and minimum wage.

Inflation targeting

Having the Fed target an inflation rate and using monetary policy tools to help the economy achieve the target.

Stagflation

High rates of inflation and unemployment at the same time

Demand Pull inflation short run vs. Long run

In the short run, demand pull inflation increases price level and real output. In the long run, demand pull inflation increases the price level, but not the real output.

Monetary rule

Increasing the money supply at the same rate as the potential annual rate of increase in real GDP

Mainstream view

Instability arises from price stickiness and unexpected shocks in AD or AS. Sticky prices make it hard for the economy to quickly adjust to shocks from unexpected changes in AD or AS.

Equation of exchange

MV=PQ where M is the money supply, V is velocity of money, P is the price level, and Q is they quantity of goods and services produced.

Mainstream view on policy

Mainstream economists believe that discretionary fiscal and monetary policy are effective. They think velocity of money is unstable and there is a loose link between changes in money supply and aggregate demand. Monetary rule does not work in their opinion. Fiscal policy is good, but only in situations where monetary policy is ineffective. Oppose balanced budget because it is pro cyclical rather than fighting recessionary or inflationary tendencies.

What do supply siders focus on?

Marginal tax rates (rates on extra dollars of income)

Monetarist and new classical view on intervention

Monetarists and new classical economists believe that intervention causes instability and monetary rule should be used. They have also more recently suggested inflation targeting. They do not like fiscal policy and would like to see a balanced budged policy.

Monetarist view of speed of self correction

Monetarists believe that there will be slow and temporary changes in output but in the long run it will return to full employment

Monetarist view on velocity

Monetarists believe that velocity i of money is relatively stable in the sense that it is stable as a percentage of GDP.

What is PQ?

Nominal GDP

Long run Equilibrium

Occurs at the price level and output where aggregate demand crosses the long run aggregate supply curve and also crosses the short run aggregate supply curve. All three intersect at one spot in long run.

Price Level surprises

RET economists believe that unanticipated price level changes cause short run changes in real output because people have misconceptions about the economy. But, when price level changes are expected there is no change in real output because people anticipate it and counteract the effects.

Disinflation

Reductions in the inflation rate from year to year

Insider-outsider theory

Relationships cause downward wage inflexibility. During a recession outsiders (less essential workers to a firm) may take lower wages to stay with the firm but the firm won't lower wages because it does not want to alienate insiders (essential to the firm)

Adverse aggregate supply shocks

Sudden changes in per unit production costs (wars or change in resource prices) that cause cost push inflation and recession. Shifts aggregate supply to the left.

Aggregate supply shocks

Sudden large increases in resource costs that jolt an economy's short run aggregate supply curve leftward. This causes unemployment and inflation to rise at the same time.

Supply side economics

The view that aggregate supply is active rather than passive in explaining changes in the price level and unemployment.

RET view

There will be rapid adjustment and self correction in the economy with little or no change in output. Based on the two assumptions that people understand the economy very well and adjust, and the economy is so competitive that things adjust very quickly.

What is the view of supply siders on taxes and saving

They believe that higher marginal tax rates reduce incentives to work, save, and invest. This leads to misallocation of resources and a decrease in productivity and aggregate supply. They call for cuts in marginal tax rates.

Long run vertical Phillips Curve

This curve depicts no trade off between inflation and unemployment. It is a vertical curve at the natural rate of unemployment. There can be inflation, but it is all consistent with the natural rate of unemployment.

Real Business Cycle Theory

This view believes that instability is caused by factors influencing aggregate supply instead of monetary factors causing changes in AD. They believe that changes in technology and resources affect productivity and thus the long run growth rate of Aggregate supply. It will shift the long run aggregate supply curve. The economy does not just change because of consumer expectations and stuff like that.

Coordination failures

This view believes that instability is caused by people not being able to coordinate their actions to achieve an optimal equilibrium. For example, if people expect a recession and cut spending and employment and contribute to the recession. If they realized that they could increase spending and employment then they could actually counter the recession instead of contributing to it.

New classical economics

Usually monetarists or RET economists who say that there are internal mechanisms in the economy that will automatically move the economy back to full employment and government intervention is bad.

Monetarism

View that is focused on the money supply, holds that the market is highly competitive, and says that the market system gives the economy a high amount of stability.

Long Run

When input prices are fully flexible and responsive to changes in the price level. Business profits and employment go back to original normal levels.

Short Run

When input prices are inflexible or even totally fixed. Not responsive to changes in price level, so an increase in price level raises business profits and real output.

Demise of stagflation

When there is a recession, wages go down, there is more competition, and in the 80s OPEC lost its monopoly power. All of this caused the short run aggregate supply to increase, meaning that unemployment and the price level fall. This will bring it back to the normal Phillips curve.