Question

Assume there is a particular short-run aggregate supply curve for an economy and the curve is relevant for several years. Use the AD-AS analysis to show graphically why higher rates of inflation over this period would be associated with lower rates of unemployment, and vice versa. What is this inverse relationship called?

Short answer

The inverse relationship between inflation and unemployment is called the Phillips Curve.

Step-by-step solution

Understanding the AD-AS Model

The Aggregate Demand (AD) and Aggregate Supply (AS) model helps explain economic indicators such as inflation and unemployment. The Aggregate Demand curve (AD) shows the total spending on goods and services at each price level, while the short-run Aggregate Supply curve (SRAS) represents the total production output at different price levels.

The Short-run AS Curve and Inflation

The Short-run Aggregate Supply (SRAS) curve is upward sloping, indicating that as the price level increases (inflation rises), firms are willing to produce more. This is because higher prices can lead to higher revenues and profits, encouraging firms to increase output.

Aggregate Demand and Shifts in the AD Curve

An increase in aggregate demand, due to factors like higher consumer spending or investment, shifts the AD curve to the right. This shift leads to a higher price level and higher output, resulting in higher inflation and lower unemployment. Conversely, a decrease in AD shifts the curve to the left, leading to lower price levels, reduced output, and potentially higher unemployment.

Graphical Representation of AD-AS Model

Draw a graph with the price level on the vertical axis and real output (GDP) on the horizontal axis. Plot the initial AD and SRAS curves intersecting at the initial equilibrium. Then, show a rightward shift of the AD curve to demonstrate how increased demand leads to a higher price level and lower unemployment.

Inverse Relationship Explained

The inverse relationship between inflation and unemployment seen in the AD-AS model is known as the Phillips Curve. It illustrates that in the short-run, as inflation increases, unemployment tends to decrease, and vice versa.

Key concepts

Phillips Curve

The Phillips Curve is a key economic concept that illustrates the inverse relationship between inflation and unemployment. Essentially, it suggests that when inflation is high, unemployment tends to be low, and when inflation is low, unemployment tends to be high. This curve emerged from observing post-World War II economic data, famously compiled by A.W. Phillips, who tracked wage inflation and unemployment rates in the United Kingdom.

The Phillips Curve reflects the trade-off policy makers face between inflation control and maintaining lower unemployment levels. However, it's important to note that the Phillips Curve primarily applies to the short run. Over the long term, the relationship can be more complex.

In practice, if a government or central bank seeks to reduce unemployment, they might accept a higher inflation rate to achieve this. Conversely, reducing inflation might increase unemployment. This delicate balance profoundly influences economic policy decisions.

Short-run Aggregate Supply

The Short-run Aggregate Supply (SRAS) curve represents the relationship between the price level and the quantity of goods and services that firms in an economy are willing to supply, while some resource prices remain fixed. In the short run, this curve is typically upward sloping.

Firms respond to higher price levels by increasing production because they anticipate higher profits, assuming that the prices of their inputs or resources have not yet adjusted upwards. This ability to produce more with existing resources allows the economy to expand output temporarily.

Factors influencing the SRAS curve include:

• Changes in labor market conditions, such as wage adjustments.
• Variations in resource availability, like raw materials.
• Advancements in technology and productivity improvements.
• Temporary supply side disruptions, such as natural disasters.

These elements can cause shifts in the SRAS curve, affecting overall economic output and price levels.

Aggregate Demand

Aggregate Demand (AD) depicts the total demand for goods and services within an economy at various price levels over a specific period. This curve is downward sloping, reflecting the negative relationship between the price level and the quantity of real GDP demanded.

Several components influence aggregate demand:

• Consumption: Changes in consumer spending, which can be affected by preferences, income levels, and taxes.
• Investment: Variations in business investments based on interest rates and economic expectations.
• Government Spending: Public sector effects on economic activity through fiscal policies.
• Net Exports: The balance of trade, influenced by foreign demand and exchange rates.

A shift to the right in the AD curve usually indicates an increase in demand across the economy, leading to higher output and inflation. On the other hand, a leftward shift suggests a decline in total demand, potentially bringing about lower output and reduced inflation.

Inflation and Unemployment Relationship

The relationship between inflation and unemployment is a central topic in macroeconomics and is closely tied to the Phillips Curve concept. In the short run, as indicated by the Phillips Curve, there's often an inverse relationship between these two metrics.

In periods of high demand, businesses experience increased sales, prompting them to hire more workers, thus reducing unemployment. This escalation in demand can lead to price increases, resulting in higher inflation. Contrarily, in times of lower demand, businesses produce less, leading to layoffs or hiring freezes, thereby increasing unemployment and reducing inflationary pressures.

This short-term dynamic suggests policy choices: boosting the economy might reduce unemployment but increase inflation, whereas taming inflation could result in higher unemployment. Over the long term, however, the relationship can differ considerably as factors like expectations, technological changes, and labor market policies come into play. Policymakers must carefully navigate these complex interactions to maintain economic stability and growth.