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Macroeconomics,Lecture 14 Supply Shock,1,Introduction,Objective Introducing the supply shock and its impact on the economy Discuss the policy from the supply side economics that deals with the stagflation Discuss the empirical wage and price equation, the dual Philips curves.,2,Supply shock and its impact on the economy,What is the supply shock The 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.,3,Supply shock and its impact on the economy,The impact of the (negative) supply shock shift the aggregate supply curve to the left and therefore decrease the output, increase the price (see the figure),4,Supply shock and its impact on the economy,The impact of the (negative) supply shock (continued),5,Supply shock and its impact on the economy,The 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).,6,Supply shock and its impact on the economy,The impact of the (negative) supply shock (continued),7,Supply shock and its impact on the economy,The case study, the oil crisis,8,Supply shock and its impact on the economy,The 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 1960’s. 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.,9,Supply shock and its impact on the economy,The case study, the oil crisis (continued) Many have argued that the stagflations occurred in 1970’s and 1980’s are due to the oil crisis. The breakdown of the OPEC.,10,The 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 output Labor saving, capital saving or neutral technical progress.,11,The technical process as a supply shock,What is the technical progress (continued)? Consider the following the production functions: Y=?L Yp=?K Y=AK1-?L? The increase in ?,? and A can be understood as the technical progress respectively in labor saving, capital saving and neutral.,12,The technical process as a supply shock,The choice of technical progress Depending on the relative price of labor and capital This seems to suggest that in the developed countries, labor saving is more desired than in developing countries Technical progress in U.S., German and China (see the figure in the next page),13,The technical process as a supply shock,The choice of technical progress (continued),14,The technical process as a supply shock,The 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.,15,The technical process as a supply shock,The impact of technical progress (continued),16,The technical process as a supply shock,The 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.,17,The technical process as a supply shock,The 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.,18,The technical process as a supply shock,The impact of technical progress (continued) The overall impact Output increases Investment? Interest rate? Price decreases Employment?,19,The technical process as a supply shock,The impact of technical progress, the neoclassical analysis Marginal product under Cobb-Dauglass production function MPK=(1- ?)AK1-?L?-1 MPL=?AK-?L? Technical progress (increase in A) will shift the MPK and MPL to the left (see the figure in the next page),20,The technical process as a supply shock,The impact of technical progress, the neoclassical analysis (continued),21,The technical process as a supply shock,The impact of technical progress, the neoclassical analysis (continued) Consequently, the demand for capital and labor will be increased, so will be the output.,22,The dual Philips curve,The original Philips curve (Philips 1958) Relating the growth rate of nominal wage to the unemployment rate The standard Philips curve (Samuelson and Solow (1961) Relating the inflation rate to the unemployment rate,23,The dual Philips curve,The 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.,24,The dual Philips curve,The model dual Philips curves (continued) The dual Philips curve in U.S.,25,The dual Philips curve,The model dual Philips curves (continued) The dual Philips curve in Germany,26,The dual Philips curve,The model dual Philips curves (continued) The dual Philips curve in China (setting ?n = 0, ?? = 0 and ?? = 0),27,The supply-side economics,Anti-stagflation policy If 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.,28,The supply-side economics,Tax cut as a policy core Reasoning: Encourage people to search for work Simulate the investment and therefore create capacity More tax cut for company First, adopted by Regan administration, followed by other republic administration.,29,The supply-side economics,Issues and disputes Tax 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.,30,The supply-side economics,Important Implication Macroeconomic policy can also effect the supply side of the economy. This is especially important for the economy in the long run.,31,