MacroeconomicsMacroeconomicsLecture 14Supply Shock1IntroductionObjective Introducing the supply shock and its impact on the economy Discuss the policy from the supply side economics that deals with the stagflationDiscuss the empirical wage and price equation, the dual Philips curves. 2Supply shock and its impact on the economyWhat is the supply shockThe shock (or an economic change) that make the aggregate supply curve to shift.The negative supply shock is to make the aggregate supply to shift the left.The positive supply shock is to make the aggregate supply curve shift to the right.3Supply shock and its impact on the economyThe impact of the (negative) supply shockshift the aggregate supply curve to the left and therefore decrease the output, increase the price (see the figure)4Supply shock and its impact on the economyThe impact of the (negative) supply shock (continued)5Supply shock and its impact on the economyThe impact of the (negative) supply shock (continued)When output decreases, the employment will also decrease. This indeed generates the stagflation.Shift the Philips curve to the right (see the figure).6Supply shock and its impact on the economyThe impact of the (negative) supply shock (continued)7Supply shock and its impact on the economyThe case study, the oil crisis8Supply shock and its impact on the economyThe case study, the oil crisis (continued)Between 1973 and 1981, the international oil price has been increased almost by three times comparing to the price in 1960s. Such a sharp increase is brought by two oil crisis that have occurred in 1973 and 1980.It is the OPEC that may response to these two oil crisis. 9Supply shock and its impact on the economyThe case study, the oil crisis (continued)Many have argued that the stagflations occurred in 1970s and 1980s are due to the oil crisis.The breakdown of the OPEC.10The technical process as a supply shock What is the technical progress?The new technology that make the output increase at the same inputs or input decrease at the same outputLabor saving, capital saving or neutral technical progress. 11The technical process as a supply shockWhat is the technical progress (continued)?Consider the following the production functions:Y=LYp=KY=AK1-L The increase in , and A can be understood as the technical progress respectively in labor saving, capital saving and neutral. 12The technical process as a supply shockThe choice of technical progressDepending on the relative price of labor and capitalThis seems to suggest that in the developed countries, labor saving is more desired than in developing countriesTechnical progress in U.S., German and China (see the figure in the next page)13The technical process as a supply shockThe choice of technical progress (continued)14The technical process as a supply shockThe impact of technical progress (using labor saving as an example)The first impact will be the shift in the production function (see the figure in the next page) and therefore, at the given output level (determined by the aggregate demand), employment is reduced. This indicates that the technical progress may cause unemployment.15The technical process as a supply shockThe impact of technical progress (continued)16The technical process as a supply shockThe impact of technical progress (continued)The second impact is the reduce in the price per unit output, and therefore cause the aggregate supply curve shifts to the right. This indicates that technical progress is essentially a positive supply shock. 17The technical process as a supply shockThe impact of technical progress (continued)The shift in the aggregate supply curve will make price reduced and output increase. Therefore, employment will be recovered. This indicates that the overall effect on employment is not clear, but since price is reduced, the Philips curve is likely to shift to the left.18The technical process as a supply shockThe impact of technical progress (continued)The overall impactOutput increasesInvestment?Interest rate?Price decreasesEmployment?19The technical process as a supply shockThe impact of technical progress, the neoclassical analysisMarginal product under Cobb-Dauglass production function MPK=(1- )AK1-L-1 MPL=AK-LTechnical progress (increase in A) will shift the MPK and MPL to the left (see the figure in the next page)20The technical process as a supply shockThe impact of technical progress, the neoclassical analysis (continued)21The technical process as a supply shockThe impact of technical progress, the neoclassical analysis (continued)Consequently, the demand for capital and labor will be increased, so will be the output.22The dual Philips curveThe original Philips curve (Philips 1958)Relating the growth rate of nominal wage to the unemployment rateThe standard Philips curve (Samuelson and Solow (1961)Relating the inflation rate to the unemployment rate23The dual Philips curveThe model dual Philips curves (with expectation and supply shock)The dual Philips curve in Flaschel, Gong and Semmler (2001,2002) where p is the inflation rate, w is the growth rate in nominal wage, N is the employment rate, U is the capacity utilization, is the expected inflation rate, x is the growth rate in labor productivity. 24The dual Philips curveThe model dual Philips curves (continued)The dual Philips curve in U.S.25The dual Philips curveThe model dual Philips curves (continued)The dual Philips curve in Germany26The dual Philips curveThe model dual Philips curves (continued)The dual Philips curve in China (setting n = 0, = 0 and = 0)27The supply-side economicsAnti-stagflation policyIf stagflation is caused by a negative supply shock, then an appropriate policy is to make a positive supply shock so as to shift the aggregate supply to the right This indeed generates the supply-side economics.28The supply-side economicsTax cut as a policy coreReasoning: Encourage people to search for workSimulate the investment and therefore create capacityMore tax cut for companyFirst, adopted by Regan administration, followed by other republic administration. 29The supply-side economicsIssues and disputesTax cut is also an expansionary fiscal policy.Its impact on the supply side of economy may be more delayed comparing to the short run effect of demand expansionary.Creating debt problem to the government.Income distribution more toward the rich people. This is especially challenged by the democratic.30The supply-side economicsImportant ImplicationMacroeconomic policy can also effect the supply side of the economy. This is especially important for the economy in the long run. 31