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4,500 400 450 4,000 4,000
5,000 400 500 4,500 4,300
5,000 4,600
Calculate net exports at each level of GDP.
2. If domestic expenditure (the sum of C 1 I 1 G in the 3. Now raise exports to $650 and find the equilibrium
economy described in Test Yourself Question 1) is as again. How large is the multiplier?

1. Explain the logic behind the finding that variable
imports reduce the numerical value of the multiplier.

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Bringing in the Supply Side:
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].

T he previous chapter taught us that the position of the economy™s total expenditure
(C 1 I 1 G 1 (X 2 IM)) schedule governs whether the economy will experience a
recessionary or an inflationary gap. Too little spending leads to a recessionary gap. Too
much leads to an inflationary gap. Which sort of gap actually occurs is of considerable
practical importance, because a recessionary gap translates into unemployment whereas
an inflationary gap leads to inflation.
But the tools provided in Chapter 9 cannot tell us which sort of gap will arise be-
cause, as we learned, the position of the expenditure schedule depends on the price
level”and the price level is determined by both aggregate demand and aggregate sup-
ply. So this chapter has a clear task: to bring the supply side of the economy back into
the picture.
Doing so will put us in a position to deal with the crucial question raised in earlier
chapters: Does the economy have an efficient self-correcting mechanism? We shall see
that the answer is “yes, but”: Yes, but it works slowly. The chapter will also enable us
to explain the vexing problem of stagflation”the simultaneous occurrence of high un-
employment and high inflation”which plagued the economy in the 1980s and which
some people worry may stage a comeback.

Why Nominal Wages and Prices Won™t Fall (Easily)
Why the Aggregate Supply Curve Slopes Upward
Does the Economy Have a Self-Correcting Demand-Side Fluctuations
Shifts of the Aggregate Supply Curve
Supply-Side Fluctuations
EQUILIBRIUM OF AGGREGATE DEMAND An Example from Recent History: Deflation in Japan
Demand Inflation and Stagflation
A U.S. Example

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Part 2
200 The Macroeconomy: Aggregate Supply and Demand

The financial press in 2007 and 2008 was full of stories about the possible
return of the dreaded disease of stagflation, which plagued the U.S. econ-
omy in the 1970s and early 1980s. Many economists, however, found this
talk unduly alarming.
On the surface, the very existence of stagflation”the combination of
economic stagnation and inflation”seems to contradict one of our Ideas for
Beyond the Final Exam from Chapter 1: that there is a trade-off between inflation and un-
employment. Low unemployment is supposed to make the inflation rate rise, and high
unemployment is supposed to make inflation fall. (This trade-off will be discussed in
more detail in Chapter 16.) Yet things do not always work out this way. For example,
both unemployment and inflation rose together in the early 1980s and then fell together
in the late 1990s. Why is that? What determines whether inflation and unemployment
move in opposite directions (as in the trade-off view) or in the same direction (as dur-
ing a stagflation). This chapter will provide some answers.

In earlier chapters, we noted that aggregate demand is a schedule, not a fixed number.
The aggregate supply
curve shows, for each The quantity of real gross domestic product (GDP) that will be demanded depends on the
possible price level, the price level, as summarized in the economy™s aggregate demand curve. The same point ap-
quantity of goods and serv-
plies to aggregate supply: The concept of aggregate supply does not refer to a fixed number,
ices that all the nation™s
but rather to a schedule (an aggregate supply curve).
businesses are willing to
The volume of goods and services that profit-seeking enterprises will provide depends
produce during a specified
on the prices they obtain for their outputs, on wages and other production costs, on the
period of time, holding all
capital stock, on the state of technology, and on other things. The relationship between the
other determinants of ag-
gregate quantity supplied price level and the quantity of real GDP supplied, holding all other determinants of quantity
constant. supplied constant, is called the economy™s aggregate supply curve.
Figure 1 shows a typical aggregate supply curve. It slopes upward, meaning that as
prices rise, more output is produced, other things held constant. Let™s see why.

Why the Aggregate Supply Curve Slopes Upward
Producers are motivated mainly by profit. The profit made by producing an additional
unit of output is simply the difference between the price at which it is sold and the unit
cost of production:
Unit profit 5 Price 2 Unit cost
F I GU R E 1
An Aggregate Supply The response of output to a rising price level”which is what
the slope of the aggregate supply curve shows”depends
on the response of costs. So the question is: Do costs rise
along with selling prices, or not?
The answer is: Some do, and some do not. Many of the
prices that firms pay for labor and other inputs remain fixed
for periods of time”although certainly not forever. For ex-
Price Level

ample, workers and firms often enter into long-term labor
contracts that set nominal wages a year or more in advance.
Even where no explicit contracts exist, wage rates typically
adjust only annually. Similarly, a variety of material inputs
are delivered to firms under long-term contracts at pre-
arranged prices.
This fact is significant because firms decide how much to
produce by comparing their selling prices with their costs of
Real GDP
production. If the selling prices of the firm™s products rise

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Chapter 10 201
Bringing in the Supply Side: Unemployment and Inflation?

while its nominal wages and other factor costs are fixed, production becomes more prof-
itable, and firms will presumably produce more.
A simple example will illustrate the idea. Suppose that, given the scale of its operations,
a particular firm needs one hour of labor to manufacture one additional gadget. If the
gadget sells for $9, workers earn $8 per hour, and the firm has no other costs, its profit on
this unit will be
Unit profit 5 Price 2 Unit cost
5 $9 2 $8 5 $1
If the price of the gadget then rises to $10, but wage rates remain constant, the firm™s profit
on the unit becomes
Unit profit 5 Price 2 Unit cost
5 $10 2 $8 5 $2
With production more profitable, the firm presumably will supply more gadgets.
The same process operates in reverse. If selling prices fall while input costs remain rel-
atively fixed, profit margins will be squeezed and production cut back. This behavior is
summarized by the upward slope of the aggregate supply curve: Production rises when
the price level (henceforth, P) rises, and falls when P falls. In other words,
The aggregate supply curve slopes upward because firms normally can purchase labor
and other inputs at prices that are fixed for some period of time. Thus, higher selling
prices for output make production more attractive.1
The phrase “for some period of time” alerts us to the important fact that the aggre-
gate supply curve may not stand still for long. If wages or prices of other inputs
change, as they surely will during inflationary times, then the aggregate supply curve
will shift.

Shifts of the Aggregate Supply Curve
So let™s consider what happens when input prices change.

The Nominal Wage Rate The most obvious determinant of the position of the aggre-
gate supply curve is the nominal wage rate (sometimes called the “money wage rate”).
Wages are the major element of cost in the economy, accounting for more than 70 percent
of all inputs. Because higher wage rates mean higher costs, they spell lower profits at any
given selling prices. That relationship explains why companies have sometimes been
known to dig in their heels when workers demand increases in wages and benefits. For ex-
ample, negotiations between General Motors and the United Auto Workers led to a brief
strike in September 2007 because GM felt it had to reduce its labor costs in order to survive.
Returning to our example, consider what would happen to a gadget producer if the
nominal wage rate rose to $8.75 per hour while the gadget™s price remained $9. Unit profit
would decline from $1 to
$9.00 2 $8.75 5 $0.25
With profits thus squeezed, the firm would probably cut back on production.
Thus, a wage increase leads to a decrease in aggregate quantity supplied at current
prices. Graphically, the aggregate supply curve shifts to the left (or inward) when nominal
wages rise, as shown in Figure 2 on the next page. In this diagram, firms are willing to sup-
ply $6,000 billion in goods and services at a price level of 100 when wages are low (point
A). But after wages increase, the same firms are willing to supply only $5,500 billion at this

There are both differences and similarities between the aggregate supply curve and the microeconomic supply

curves studied in Chapter 4. Both are based on the idea that quantity supplied depends on how output prices
move relative to input prices. But the aggregate supply curve pertains to the behavior of the overall price level,
whereas a microeconomic supply curve pertains to the price of some particular commodity.

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Part 2
202 The Macroeconomy: Aggregate Supply and Demand

price level (point B). By similar reasoning, the aggre-
F I GU R E 2
gate supply curve will shift to the right (or outward) if
A Shift of the Aggregate Supply Curve
wages fall.
S1 (higher wages)
An increase in the nominal wage shifts the aggregate
S0 (lower wages)
supply curve inward, meaning that the quantity sup-
plied at any price level declines. A decrease in the
nominal wage shifts the aggregate supply curve out-
Price Level (P )

ward, meaning that the quantity supplied at any
price level increases.
The logic behind these shifts is straightforward.
Consider a wage increase, as indicated by the brick-
colored line in Figure 2. With selling prices fixed at 100
5,500 6,000
in the illustration, an increase in the nominal wage
Real GDP (Y )
means that wages rise relative to prices. In other words,
the real wage rate rises. It is this increase in the firms™
NOTE: Amounts are in billions of dollars per year.
real production costs that induces a contraction of
quantity supplied”from A to B in the diagram.

Prices of Other Inputs In this regard, wages are not unique. An increase in the price
of any input that firms buy will shift the aggregate supply curve in the same way. That is,
The aggregate supply curve is shifted to the left (or inward) by an increase in the price
of any input to the production process, and it is shifted to the right (or outward) by any


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