Question

1.(i) Using the AD/AS model, discuss the changes to the economy that the Phillips curve explains well, and describe under what conditions the Phillips curve fails to explain economic behavior. Include graphs of the Phillips curve and the AD/AS model in your answer

2.(ii) In the late 1990s, the U.S. economy experienced a period of extremely low inflation and extremely low unemployment. Use the AD/AS model to explain what sort of change in the economy would cause this. Include a graphical analysis in your answer, and provide two examples of what might bring about this event.

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Answer 1

Solution(s):

Answer:

          The Aggregate output and price level do not remain constant for a long time, they keep rising and falling. The change in the aggregate price level and the output is caused by the shift in the AS and AD curves.

Aggregate Demand (AD): The Aggregate Demand curve describes the relationship between price levels and the quantity of output that firms are willing to provide. It is derived on the basic law of demand.

Aggregate Supply (AS): The Aggregate Supply curve describes the relationship between price levels and the quantity of output that firms are willing to provide.

Phillips curve: The Phillips curve explains the relationship between inflation and unemployment. In the short-run, inflation and unemployment are inversely related; as one quantity increases, the other decreases. In the long-run, there is no trade-off. If unemployment is high, inflation will be low; if unemployment is low, inflation will be high.

The Phillips Curve Related to AD & AS in an Economy:

            The Phillips curve and aggregate demand share similar components. The Phillips curve is the relationship between inflation, which affects the price level aspect of aggregate demand, and unemployment, which is dependent on the real output portion of aggregate demand. Consequently, it is not far-fetched to say that the Phillips curve and aggregate demand are actually closely related.

            The following graph shows, the Aggregate demand and Aggregate supply curves are analogous to the market demand and market supply curves. In that case, the AD curve has an inverse relation with the price level and the aggregate supply.   

            Let's assume that Aggregate Supply (AS) is stationary, and that aggregate demand starts with the curve, AD₁. There is an initial equilibrium price level and real GDP output at point A. Now, imagine there are increases in aggregate demand, causing the curve to shift right to curves AD₂ through AD4. As aggregate demand increases, unemployment decreases as more workers are hired, real GDP output increases, and the price level increases; this situation describes a demand-pull inflation scenario.

  https://figures.boundless.com/21256/medium/12-02-20at-203.00.41-20pm.png

      As aggregate demand increases from AD1 to AD4, the price level and real GDP increases. This translates to corresponding movements along the Phillips curve as inflation increases and unemployment decreases.

            As more workers are hired, unemployment decreases. Moreover, the price level increases, leading to increases in inflation. These two factors are captured as equivalent movements along the Phillips curve from points A to D. At the initial equilibrium point A in the aggregate demand and supply graph, there is a corresponding inflation rate and unemployment rate represented by point A in the Phillips curve graph. For every new equilibrium point (points B, C, and D) in the aggregate graph, there is a corresponding point in the Phillips curve. This illustrates an important point: changes in aggregate demand cause movements along the Phillips curve.

The U.S. economy experience in 1990s with AD/AS:

            In the late 1990s, the U.S. economy experienced a period of extremely low inflation and extremely low unemployment. Labor’s weaker position in the 1990s meant that despite low unemployment, workers were not able to win higher wages that would have spurred inflation.

            The long period of stable prices and low interest rates in the United States now seems to be coming to a close. The cost of the Iraq War and rising oil prices, among other factors, has fuelled expectations of a resurgence of inflation. At the same time, the near jobless recovery from the last recession might suggest that the natural rate of unemployment is on the rise again and that we are witnessing yet another twist in the strange history of the Phillips curve.

            With inflation rising (albeit slowly, and still relatively mild at around 4.2%), some business sectors will no doubt begin clamoring for tighter monetary policies that sacrifice job-creation and wage growth by slowing the economy growth. But these fears of inflation are probably misplaced. A moderate rate of inflation is conducive to the growth of real investment, and in the context of a decades-long squeeze on workers’ wage share, there is room to expand employment without setting off a wage-price spiral. What workers need is not greater fiscal and monetary austerity, but rather a revival of a Keynesian program of ”employment targeting“ that would sustain full employment and empower workers to push for higher wages. It’s not likely, however, that the owners of capital and their political allies would sit idly by were such a program to be enacted.

            In the United States Congressional Budget Office (CBO) estimates annual potential output for the purpose of federal budget analysis. The following graphs the CBO’s estimates of U.S. potential output from 1990 to 2011 are represented by the orange line and the actual values of U.S. real GDP over the same period are represented by the blue line. Years shaded purple on the horizontal axis correspond to periods in which actual aggregate output fell short of potential output, years shaded green to periods in which actual aggregate output exceeded potential output.

http://www.reduceimages.com/download.php?image=5d043c8d33

            This figure shows the performance of actual and potential output in the United States from 1990 to 2011. The orange line shows estimates of U.S. potential output, produced by the Congressional Budget Office, and the blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggregate output fell below potential output, and the green-shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000. Actual aggregate output was significantly above potential output in the boom of the late 1990s, and a huge shortfall occurred after the recession of 2007–2009.

            In the long run, as the size of the labor force and the productivity of labor both raise, the level of real GDP that the economy is capable of producing also rises. Indeed, one way to think about long - run economic growth is that it is the growth in the economy’s potential output. We generally think of the long - run aggregate supply curve as shifting to the right over time as an economy experiences long - run growth.