26
Supply-Side Equilibrium:
Unemployment and
Inflation?
We might as well reasonably dispute whether it is the
upper or the under blade of a pair of scissors that
cuts a piece of paper, as whether value is governed
by [demand] or [supply].
ALFRED MARSHALL
Contents
● The Aggregate Supply Curve
● Equilibrium of Aggregate Demand and
Supply
● Recessionary and Inflationary Gaps
Revisited
● Adjusting to a Recessionary Gap: Deflation
or Unemployment?
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Contents (continued)
● Adjusting to an Inflationary Gap: Inflation
● Stagflation from a Supply Shock
● Inflation and the Multiplier
● A Role for Stabilization Policy
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The Aggregate Supply Curve
● The aggregate supply curve shows the
relationship between the price level and the
quantity of real GDP supplied, holding all
other determinants of quantity supplied
constant.
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26-1 An Aggregate
Supply Curve
FIGURE
Price Level
S
S
Real GDP
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The Aggregate Supply Curve
● Why the Aggregate Supply Curve Slopes
Upward
♦ Firms normally can purchase labor and other
inputs at prices that are fixed for some period
of time.
♦ Higher prices, thus, mean higher profits and
more incentive to produce.
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The Aggregate Supply Curve
● Shifts of the Aggregate Supply Curve
♦ Costs of production are constant along the AS
curve.
♦  costs of production  shifts in the AS
curve
■The money wage rate
■Prices of other inputs
■Technology and productivity
■Available supplies of labor and capital
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26-2 A Shift of the
Aggregate Supply Curve
FIGURE
S1 (higher wages)
S0 (lower wages)
B
Price Level
100
A
S1
S0
5,500 6,000
Real GDP
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The Aggregate Supply Curve
● Shifts of the Aggregate Supply Curve
♦  cost of production  inward shift of AS
curve
■Money wage rate
■Interest rate
■Materials prices
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The Aggregate Supply Curve
● Shifts of the Aggregate Supply Curve
♦  costs of production  outward shift of AS
curve
■Improvements in technology
■Increases in productivity
■Increases in supplies of labor and capital
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Equilibrium of Aggregate
Demand and Supply
● Price level adjustments  AS-AD
equilibrium
● Imbalance between AS and AD  
inventories   price   quantity of AS
and AD
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26-3 Equilibrium of Real
GDP and the Price Level
FIGURE
S
Price Level
D
130
120
110
100
90
80
E
S
D
5,200 5,600 6,000 6,400 6,800
Real GDP
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26-1 Determination of the
Equilibrium Price Level
TABLE
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Recessionary and
Inflationary Gaps Revisited
● Short run: AS-AD equilibrium may or may
not equal full employment GDP
♦ Recessionary gap: Equilibrium GDP <
Potential GDP
♦ Inflationary gap: Equilibrium GDP >
Potential GDP
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Recessionary and
Inflationary Gaps Revisited
● Long-run: market forces make equilibrium
GDP = potential GDP
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26-5 The Elimination of a
Recessionary Gap
FIGURE
Potential
GDP
S0
Price Level
S1
D
E
100
B
F
S0
Recessionary
gap
D
S1
5,000
6,000
Real GDP
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Adjusting to a Recessionary
Gap
● When unemployment exists, if money
wages fall:
♦ The aggregate supply curve will shift outward
♦ Full employment will be attained eventually
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Adjusting to a Recessionary
Gap
● In the real economy, however, wage
reductions are slow and uncertain,
particularly in the post-World War II period.
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Adjusting to a Recessionary
Gap
● There are several possible reasons why
wages are so sticky in the downward
direction:
♦ Institutional rigidities
♦ Psychological resistance
♦ Reduced severity of business cycles
♦ Competition for the best workers
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Adjusting to a Recessionary
Gap
● With sticky wages, cyclical unemployment
may last a long time.
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Adjusting to a Recessionary
Gap
● Does the Economy Have a Self-Correcting
Mechanism?
♦ The economy will self-adjust eventually.
■ wages   demand for labor
■ prices   demand for goods and services
♦ But many people believe that government
intervention should help to speed the process.
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Adjusting to a Recessionary
Gap
● An Example from Recent History:
Disinflation in Japan the 1990s
♦ Recovery from the 1990-1991 recession was
weak and long delayed, but it did eventually
come.
♦ Practical question: How long can we afford to
wait?
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Adjusting to an Inflationary
Gap
● When GDP > full employment
♦ Price level rises
♦ Labor is in short supply
● Both forces   money wages
♦ AS curve shifts inward
♦ Employment falls
♦ Eventually eliminates the inflationary gap
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26-6 The Elimination of
an Inflationary Gap
FIGURE
Potential
GDP
S1
D
Price Level
S0
F
E
B
S1
Inflationary
gap
S0
D
Real GDP
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Adjusting to an Inflationary
Gap
● During this process, both prices and
unemployment are increasing.
● Stagflation = inflation that occurs while
the economy is growing slowly or having a
recession
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Adjusting to an Inflationary
Gap
● Demand Inflation and Stagflation
♦ In an inflationary gap, prices and wages rise
because of excess demand.
♦ Rising wages are a symptom, not a cause, of
the underlying problem.
♦ A period of stagflation is part of the normal
aftermath of a period of excessive aggregate
demand.
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Adjusting to an Inflationary
Gap
● The stagflation that follows a period of
excessive AD is comparatively benign;
output is falling, but it is still above
potential GDP.
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Adjusting to an Inflationary
Gap
● The U.S. economy has experienced two
episodes of stagflation in the last decade.
♦ The more notable one came between 1988 and
1990 – low unemployment was accompanied
by moderate inflation.
♦ A milder version of this same phenomenon
occurred in the first half of 1999; however,
inflation was generally held in check.
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Stagflation from a Supply
Shock
● Independent shifts inward in aggregate
supply are a second cause of stagflation.
● The increase in world oil prices caused such
a shift twice in the 1970s.
● Favorable supply shocks tend to push output
up and reduce inflation.
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26-7 Stagflation from an
Advance Shift in AS
FIGURE
D
S1
Price Level
(1996 = 100)
S0
A
40.0
33.6
E
S1
S0
D
4,099
4,123
Real GDP
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Inflation and the Multiplier
● Inflation   size of the multiplier
● As long as the aggregate supply curve is
upward sloping,  AD   price level
● This, in turn, drains off some of the higher
real demand.
♦  purchasing power of consumer wealth
♦  net exports
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26-8 Inflation and the
Multiplier
FIGURE
D1
D0
Price Level
S
$800
billion
120
E1
E0
100
A
S
D0
D1
6,000 6,600 6,800
Real GDP
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A Role for Stabilization
Policy
● Since the economy’s self-correcting
mechanism sometimes works slowly, there
is room for government stabilization policy
to improve the workings of the free market.
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