Page 338 - Economics

CONFIRMING PAGES

PART FIVE
290
Long-Run Perspectives and Macroeconomic Debates
This analysis yields two generalizations: shifts rightward from AS to AS . The negative GDP gap
1
2
• If the government attempts to maintain full evaporates without the need for expansionary fiscal or mon-
employment when there is cost-push inflation, an etary policy, since real output expands from Q (point b ) back
1
inflationary spiral may occur. to Q f (point c ). The economy is again located on its long-run
• If the government takes a hands-off approach to cost- aggregate supply curve AS LR , but now at lower price level P 3 .
push inflation, a recession will occur. Although the There is much disagreement about this hypothetical
recession eventually may undo the initial rise in per-unit scenario. The key point of dispute is how long it would
production costs, the economy in the meantime will ex- take in the real world for the necessary downward price and
perience high unemployment and a loss of real output. wage adjustments to occur to regain the full-employment
level of output. For now, suffice it to say that most econo-
Recession and the Extended mists believe that if such adjustments are forthcoming, they
AD-AS Model will occur only after the economy has experienced a rela-
By far the most controversial application of the extended tively long-lasting recession with its accompanying high
AD-AS model is its application to recession (or depres- unemployment and large loss of output. Therefore, econo-
sion) caused by decreases in aggregate demand. We will mists recommend active monetary policy, and perhaps fiscal
look at this controversy in detail in Chapter 17; here we policy, to counteract recessions. (Key Question 4)
simply identify the key point of contention.
Suppose in Figure 15.5 that aggregate demand initially QUICK REVIEW 15.2
and that the short-run and long-run aggregate supply
is AD 1
curves are AS and AS , respectively. Therefore, as shown • In the short run, demand-pull inflation raises both the price
1
LR
by point a, the price level is P and output is Q . Now sup- level and real output; in the long run, nominal wages rise, the
1
f
pose that investment spending declines dramatically, reduc- short-run aggregate supply curve shifts to the left, and only
the price level increases.
ing aggregate demand to AD . Observe that real output • Cost-push inflation creates a policy dilemma for the
2
declines from Q to Q , indicating that a recession has government: If it engages in an expansionary policy to
1
f
occurred. But if we make the controversial assumption that increase output, an inflationary spiral may occur; if it does
prices and wages are flexible downward, the price level falls nothing, a recession will occur.
from P to P . The lower price level increases real wages for • In the short run, a decline in aggregate demand reduces real
1
2
people who are still working, since each dollar of nominal output (creates a recession); in the long run, prices and
wage has greater purchasing power. Eventually, nominal nominal wages presumably fall, the short-run aggregate
wages themselves fall to restore the previous real wage; when supply curve shifts to the right, and real output returns to its
full-employment level.
that happens, the short-run aggregate supply curve
FIGURE 15.5 Recession in the extended AD-
AS model. A recession occurs when aggregate demand The Inflation-Unemployment
shifts leftward, as from AD 1 to AD 2 . If prices and wages are
downwardly flexible, the price level falls from P 1 to P 2 . That Relationship
decline in the price level eventually reduces nominal wages, and
this shifts the aggregate supply curve from AS 1 to AS 2 . The price Because both low inflation rates and low unemployment
level declines to P 3 , and real output increases back to Q f . The rates are major economic goals, economists are vitally in-
economy moves from point a to b and then eventually to c.
terested in their relationship. Are low unemployment and
low inflation compatible goals or conflicting goals? What
AS LR
explains situations in which high unemployment and high
AS 1
inflation coexist?
AS 2
cant generalizations relating to these questions:
The extended AD-AS model supports three signifi-
Price level P 1 a • Under normal circumstances, there is a short-run
tradeoff between the rate of inflation and the rate of
P 2 b unemployment.
P 3 c • Aggregate supply shocks can cause both higher rates
AD 1
of inflation and higher rates of unemployment.
AD 2 • There is no significant tradeoff between inflation and
0 Q 1 Q f unemployment over long periods of time.
Real domestic output Let’s examine each of these generalizations.

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