Lilongwe University of Agriculture and Natural Resources

Faculty of Development Studies

Department of Agricultural and Applied Economics

Agricultural Economics II (AAE 221)

Year 2

By

Sensei: MAONGA, B.B (PhD)

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 Topic 4
KEYNESIAN THEORY OF INCOME, EMPLOYMENT
AND PRICE LEVELS

4. Introduction
• This topic highlights three fundamental aspects of aggregate supply
(AS) as follows:
• (1) The aggregate supply curve describes the price adjustment
mechanism of the economy;
• (2) The Phillips Curve (PC) links inflation and unemployment. The
Phillips Curve and aggregate supply curve are alternative ways of
looking at the same phenomena;
• (3) According to the modern Phillips Curve, inflation depends on
expectations of inflation, as well as unemployment.
• The topic also provides a distinction between short-run AS and long-
run AS. It examines the inflation-unemployment relationship and the
effect of taxes on AS – which is a key concern of the supply-side
economists.
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4.1 Short-Run and Long-Run Aggregate Supply
• It is generally assumed that the AS curve remains stable when the AD curve
shifts positions.
• The short-run in macroeconomics is a period in which nominal wages (and other
input prices) remain fixed as price level increases or decreases.
• Nominal wages may remain constant for a time even though the price level
has changed because of the following reasons:
• (1) Workers may not immediately be aware of the extent that inflation (or
deflation) has changed their real wages, and thus they may not adjust their
labor supply decisions and wage demands accordingly. The slow adjustment
of wages arises from workers’ slow reactions to or imperfect information
about changes in prices.
• (2) Many employees are hired under fixed-wage contracts. For most
employees, nominal wages remain constant for the life of the contracts,
regardless of changes in the price level.
• Thus, adjustments in nominal wages take significant periods of time to be
effected.
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Short-Run and Long-Run Aggregate Supply

 In macroeconomics, the long-run is the period in which nominal

wages are fully responsive to previous changes in the price level.
 As time passes, workers gain full information about price level
changes and the impact on real wages.

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4.1.1 Short-run Aggregate Supply
• The existence of the short-run aggregate supply curve is based on the
following assumptions:
• (1) The initial price level is at P1; (2) Firms and workers have established
nominal wages on the expectation that this price level will persist;
• (3) The price level is flexible both upward and downward.
Price level P2 b AS
P1 a
P3 c

0 Q3 Qf Q2 Real Domestic
Figure 4.1: Short-run AS curve Output
• As price level increases from P1 to P2 both profits and output increase,
moving the economy from a to b along the short-run AS curve. With high
profits, firms increase their output from Qf (full employment output) to Q2.
5
4.1.2 Long-run Aggregate Supply
• In the long-run, a rise in the price level results in higher nominal wages and
thus shifts the short-run AS curve to the left (AS1 to AS2). How?
• Conversely, a decrease in the price level reduces nominal wages and
shifts the short-run AS curve to the right (AS3). After such adjustments,
the economy obtains equilibrium at points such as b1 and c1. Thus, the
long-run AS curve is vertical .
ASLR AS2 AS1
P2 b1 a2 AS3
Price level & Nominal Wages
P1 a1

P3 a3 c1

0 Q3 Qf Q2
Figure 4.2: Long-run AS curve 6
Long-run Aggregate Supply (cont’d)

• Note that Figure 4.1 gives a static picture of what is really a

dynamic process that is shown by Figure 4.2. Think of the AS
curve as rotating counterclockwise from horizontal to vertical
with the passage of time.
• If AD is greater than potential output (Qf or Y*), intermediate
curve indicates that after one year’s time, prices will have
risen enough to partially push GDP back down to potential
output (Figure 4.2).

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Long-run Aggregate Supply (cont’d)
• The AS curve is focused as a description of the mechanism by which
prices rise or fall over time.
•  The following equation gives the aggregate supply curve:
Pt+1 = Pt[1 + λ (Y – Y*)] …………………..(1)
Where Pt+1 is next period price level, Pt is current price level,
λ (lambda) is the coefficient, which explains the linkage
between changes in output and price, Y* is the potential
output (Qf).
•  Equation (1) embodies the idea that if output (Y) is above potential
output (Y*) prices will rise and be higher next period; and if (Y) is below
(Y*) prices will fall and be lower next period. Why? Labour cost issues!!
• Prices will continue to rise or fall over time until output (Y) returns to
potential output (Y*). According to equation (1) the price keeps moving
until output is no longer above potential output.
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Long-run Aggregate Supply (cont’d)

• The speed of price adjustment is controlled by the parameter λ (lambda) in

equation (1).
• If λ is large, the AS curve moves quickly; and the AS mechanism will return the
economy to potential output (Y*) relatively quickly.
• Thus, the position of the short-run AS schedule depends on the level of
prices.
• The AS schedule passes through the full-employment level of output (Y*) at Pt+1
= Pt .
• At higher output levels there is over employment, and hence prices next
period will be higher than those this period (and vice versa with high
unemployment). This is because higher employment (lower unemployment)
means higher labour cost which has to be recovered by increasing price of
output.

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4.1.3 Equilibrium in the AD – AS Model

• Figure 4.3 shows the long-run equilibrium in the AD-AS Model,

that is extended to include the distinction between short-run and
long-run AS curves.
• Equilibrium occurs at a point where the economy’s aggregate
demand curve (AD) intersects both its short-run AS curve (AS)
and the vertical long-run AS curve (ASLR). In the long-run
equilibrium, the economy’s price level is P1 and its real output
is Qf. ASLR AS

Price level
P1
AD

0 Qf Real Domestic
Output 10
4.2 Relationship between Inflation and
Unemployment
• Because both low inflation rates and low unemployment rates are major
economic goals, economists are vitally interested in their relationship.
• Are low unemployment and low inflation compatible or conflicting goals?
• What explains the situation in which high unemployment and high
inflation rates coexist?
• The extended AD-AS Model supports three significant generalizations
relating to these questions.
• Under normal circumstances, there is a short-run trade-off between
the rate of inflation and the rate of unemployment.
• Aggregate supply shocks can cause both higher rates of inflation and
higher rates of unemployment.
• There is no significant tradeoff between inflation and unemployment
over long periods of time.
• Lets examine these generalizations through the analysis of the Phillips Curve
(PC) – named after A.W. Phillips who developed the idea in 1958 in Great
Britain.

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4.2.1 The Phillips Curve
• The Phillips Curve (PC) shows the inverse relationship between the
rate of unemployment and the rate of increase in money wages or
wage inflation (Figure 4.4).
10
Annual Rate 8
of Wage
Inflation (%) 6
4 PC
2
0 2 4 6 8

Figure 4.4: The Phillips Curve Unemployment Rate (%)

• Thus, the Phillips Curve (Figure 4.4) implies that the higher the rate of
unemployment, the lower the rate of wage inflation. (First 12
generalization).
Short-run Phillips Curve Explained
• The Phillips Curve shows that the rate of wage inflation decreases
with the increase in unemployment rate. The rate of wage inflation
is defined as gw = [(Wt+1 – Wt)/(Wt)]× 100 …………..(2)
  Where gw is rate of wage inflation,
Wt+1 is the wage rate next period,
Wt is the wage rate this period.
• With u* representing the natural rate of unemployment (NRU),
we can write the simple Phillips Curve as follows:
gw = -ε(u - u*) ……..…………………….….(3)
Where ε measures the responsiveness of wages to
unemployment, u is the actual unemployment rate,
u* is the natural rate of unemployment (NRU). 
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Short-run Phillips Curve Explained
• Equation (3) above, states that wages decline when the unemployment rate
exceeds the natural rate of unemployment, (i.e. u > u*,
• and conversely, wages rise when unemployment rate is below the natural
rate of unemployment.
• The difference between u and u*, (u – u*) is called the unemployment
gap.
• When the economy is in equilibrium, with prices stable and unemployment at
the natural rate, for wages to rise above their previous level, the
unemployment rate will have to fall below the natural rate (NRU).
• Both wages and prices will start rising, and eventually the economy will
return to the full-employment level of output (Qf) and unemployment
(NRU).
• This point can be explored by rewriting equation (2), using the definition of
the rate of wage inflation in order to look at the level of wages today
relative to the past level:
Wt+1 = Wt [1-ε (u - u*)]
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Short-run Phillips Curve Explained
• The underlying rationale of the Phillips Curve becomes apparent
when we view the short-run aggregate supply curve of Figure 4.5
below and perform a simple mental experiment.
AS
Price level P3
P2 AD3
P1 AD2
P0 AD1
AD0
0 Q0 Q1 Q2 Q3 Real output

Figure 4.5: Effect of Changes in AD on Real Output and the Price Level
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Short-run Phillips Curve Explained (Mental
Exercise)
• Suppose that in some period AD expands from AD0 to AD2, in the short-
run the price level rises from P0 to P2 and real output rises from Q0 to Q2.
A decline in the unemployment rate accompanies the increase in real
output.
• Now, compare what would have happened if the increase in AD had
been larger, say, from AD0 to AD3. The new equilibrium tells us that the
amount of inflation and the growth of real output would both have been
greater (and that the unemployment rate would have been lower) – price
level would have increased from P0 to P3 and real output would have
risen from Q0 to Q3.
• Similarly, suppose AD during the year had increased only moderately
from AD0 to AD1. Compared with the shift from AD0 to AD2, the amount
of inflation and the growth of real output would have been smaller (and
the unemployment rate higher).
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Short-run Phillips Curve Explained

• The generalization that we draw from this mental experiment is

this: Assuming a constant short-run AS curve, high rates of
inflation are accompanied by low rates of unemployment (as
presented by the Phillips Curve, Figure 4.4, ceteris paribus).

• On the basis of this evidence, it has generally been concluded that

there is a stable and predictable tradeoff between unemployment
and inflation.
• However, according to this thinking, it would be impossible to
achieve full employment without inflation.

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Rejecting the stable and predictable Phillips
Curve
• For a number of reasons (that we will see later), the idea of a stable
and predictable Phillips Curve is rejected by modern economists.
• Nevertheless, economists agree that there is a short-run tradeoff
between unemployment and inflation.
• Given AS, an increase in AD increases real output and reduces
unemployment rate.
• As the unemployment rate falls and dips below the natural rate,
the excessive spending produces demand-pull inflation.
• Conversely, when recession sets in and the unemployment rate
increases, the weak AD that caused the recession also leads to
lower inflation rates.

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Exceptional cases: Increased productivity, low
unemployment and low inflation
 Periods of exceptionally low unemployment rates and low inflation rates do
occur, but only under special sets of economic circumstances.
 Faster productivity growth, for instance, increases AS and fully blunts the
inflationary impact of a rapidly rising AD (Figure 4.6).
AS1
Price level P2 b
AS2
P3 c
P1 a AD2
AD1

0 Q1 Qf Q3 Real GDP
Figure 4.6: Growth, Full Employment and Relative Price Stability 19
 Exceptional cases: Increased productivity,
low unemployment and low inflation
(Explained)
• Normally, an increase in AD from AD1 to AD2 would move the
economy from a to b along the AS1.
• Real output would expand to its full-capacity level (Qf) and inflation
would result (price level rising from P1 to P2).
• However, due to significant increases in productivity, AS curve
shifts from AS1 to AS2. The economy moves from a to c (i.e. a→
b→ c) and not from a to b only
• Due to high productivity of resources, the economy experiences a
strong growth (expanding from Q1 to Q3), resulting into full
employment, and only very mild inflation rate (price level rising
from P1 to P3).

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4.2.2 Aggregate Supply Shocks and the Phillips
Curve
• Aggregate supply shocks can cause both higher rates of inflation and
higher rates of unemployment.
• A series of sudden, large increases in resource cost that jolt an
economy’s short-run aggregate supply curve leftward hit most of the
global economies in the 1970s. The quadrupling and 100% increases
of oil prices by the OPEC in 1973 and 1978, respectively, caused large
and rapid increases in the cost of production and distribution of
products and services.
• Other factors that cause aggregate supply shocks include major
agricultural shortfalls (severe decline in agricultural production), a
greatly depreciated currency, wage hikes (that are initially held down
by wage-price controls), and declining productivity.
• Such shocks shift the aggregate supply curve to the left and distort the
usual inflation–unemployment relationship.

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 Aggregate Supply Shocks and the Phillips
Curve
• A leftward shift of the short-run aggregate supply curve (AS1 to
AS2) increases the price level (cost-push inflation) and reduces real
output (and thus increases the unemployment rate). Figure 4.7
below, depicts this. ASLR AS2
P3 c
Price level AS1
P2 b AD2
P1 a
AD1

0 Q2 Qf Real GDP
Figure 4.7: Cost-push inflation in the extended AD-AS model 22
Cost-push Inflation in the Extended AD-AS
Model
• If the government counters the decline in real output by
increasing aggregate demand from AD1 to AD2 the price level rises
even more.
• This supports the second generalization: Aggregate supply shocks
can cause both higher rates of inflation and higher rates of
unemployment).
• That is, the economy moves in steps from a to b to c.
• In contrast, if government allows a recession to occur, nominal
wages eventually fall and aggregate supply curve shifts back
rightward to its original location.
• The economy moves from c to b and then eventually to a.

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4.2.3 Stagflation Demise (end/downfall of
stagflation)
• Tight monetary policy aimed at reducing double-digit inflation may
cause recession and increase the rate of unemployment.
• With so many unemployed work force, those who are working
accept smaller increases in their nominal wages, or in some cases,
employers reduce wages in order to preserve workers’ jobs (to avoid
retrenchment).
• Firms in return, restrain their price increases to try to retain their
relative shares of a greatly diminished market.

• Other factors that complicate stagflation even further are foreign

competitions.
• Foreign competition may hold down wage and price hikes (during
the global cost-push inflation/recession period) in several basic
industries.
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Stagflation Demise (end/downfall of stagflation)
• Deregulating some industries may likely result in wage reductions
(also known as wage-givebacks).

• A significant decline in OPEC’s monopoly powers and a reduced

reliance on oil in the production process causes a stunning decline
in the prices of oil and its derivative products such as gasoline
(petrol), diesel, and kerosene (paraffin).
• Biofuels have potential to serve as alternative to fossil fuels above.

• All these factors combined, help to reduce per unit production

costs and shift the short-run aggregate supply curve rightward
(from AS2 to AS1 in Figure 4.7).
• Employment and output expand and unemployment falls.
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4.2.4 The Long-run Phillips Curve

• The long-run Phillips Curve supports the third generalization

relating to the inflation–unemployment relationship: There is no
apparent tradeoff between inflation and unemployment.

• It is pointed out that when decades (long time) are considered, any
rate of wage inflation is consistent with the natural rate of
unemployment prevailing at that time.

• But how can there be a short-run inflation-unemployment

tradeoff but not a long-run tradeoff? Figure 4.8 provides the
answer.

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The Long-run Phillips Curve (Illustrated)

• Consider Phillips Curve in Figure 4.8 below.

PC3 PCLR
Annual rate 12 PC2 b3
of inflation
(%) 9 PC1 b2 a3

6 b1 a2 c3

3 a1 c2
c1
0 1 2 3 4 5 6 Unemployment 27rate (%
 The Long-run Phillips Curve (Discussed)
• Increases in aggregate demand (AD) beyond those consistent with full-
employment output may temporarily boost profits, output and employment
(the economy moves from a1 to b1).
• The move from a1 to b1 is consistent both with an upward-sloping AS curve
and with inflation-unemployment tradeoff implied by the Phillips Curve
analysis.
• But this short-run Phillips Curve simply is a manifestation of the principle:
When actual rate of inflation is higher than expected, profits temporarily
rise and the unemployment rate temporarily falls.
• But nominal wages will eventually catch up so as to sustain real wages.
Profits fall, negating the previous short-run stimulus to production and
employment (the economy now moves from b1 to a2).
• Consequently, there is no tradeoff between the rates of inflation and
unemployment in the long-run; (the long-run PCLR is roughly a vertical line at
the economy’s NRU. 28
4.3 Taxation and Aggregate Supply
• Taxation is a key aspect of the supply-side economics.
• Supply-side economists stress that changes in aggregate supply
are an active force in determining the levels of inflation,
unemployment and economic growth.
• Government policies can either impede or promote
rightward shifts of the short-run and long-run aggregate
supply. One such policy is taxation.
 
• Supply-side economists advance that enlargement of tax system
impairs incentives to work, save, and invest.

• In this view, high tax rates impede productivity growth and hence
slow the expansion of long-run aggregate supply.
29
Taxation and Aggregate Supply
• After reducing the after-tax rewards of workers and producers,
high tax rates reduce the financial attractiveness of work, saving,
and investing.
• Supply-siders focus their attention on marginal tax rates – the
rates on extra money of income – because those rates affect the
benefits from working, saving, or investing more.

• For example: Suppose you save money amounting to K50,000

with the FDH Bank that offers an interest rate of 12% per annum
and charges a marginal tax rate of 16.5%.
• How much would you receive at the end of 2 years? (K60,020)
• What would be the real interest rate that you get? (10.02%)

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4.3.1 Taxes and Incentives to Work

• Supply-siders believe that how long and how hard people work
depend on the amounts of additional after-tax earnings they
derive from their efforts.
• Thus, the government should reduce marginal tax rates on
earned incomes in order to induce more work, and therefore
increase aggregate inputs of labor.
•  Lower marginal tax rates would make leisure more expensive and
thus work more attractive.
• The higher opportunity cost of leisure would encourage people
to substitute work for leisure.

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Achieving an increase in productive effort

• The increase in productive effort could be achieved in many ways,

some of which are as follows:
• By increasing the number of hours worked per day or week,
• By encouraging workers to postpone retirement,
• By inducing more people to enter the labor force (job creation
and/or benefits),
• By motivating people to work harder (provision of incentives),
• By avoiding long periods of unemployment, thus, reducing
idleness.

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4.3.2 Incentives to Save and Invest
• The rewards for saving and investing reduce by high marginal tax
rates.
• Saving is a prerequisite of investment. Just like low interest rates
on savings, high marginal tax rates restrict saving.
• Thus, supply-side economists recommend lower marginal tax rates
on interest earned from saving.
• They also call for lower taxes on income from capital to ensure
that there are ready investment outlets for the economy’s
enhanced pool of savings.
• A critical determinant of investment spending is the expected
after-tax return on that investment spending.

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 Incentives to Save and Invest
• Lower marginal tax rates encourage saving and investing.
• Workers therefore, find themselves equipped with more and
technologically superior machinery and equipment.
• Labor productivity rises, and that expands aggregate supply,
which in turn keeps unemployment rates and inflation low.

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4.3.3 The Laffer curve

• In the supply-side view, reductions in marginal tax rates increase

the nation’s aggregate supply and can leave the nation’s tax
revenues unchanged or even enlarge them.
• Thus, supply-side tax cuts need not produce budget deficits.

• This idea is based on the Laffer curve, named after Arthur Laffer,
who developed it in the USA.
• The Laffer curve (Figure 4.9) depicts the relationship between
tax rates and tax revenues.
• As tax rates increase from 0 to 100%, tax revenue increases
from 0 to some maximum level (at m) and then fall to 0
(zero).

35
The Laffer curve (Illustrated)

100
Tax rate
(%) n

50 m
Maximum
p tax revenue

0 Tax Revenue (MK)

Figure 4.9: The Laffer Curve
36
The Laffer curve (Explained)
• The Laffer curve suggests that up to a point m higher tax rates will
result in larger tax revenues.
• But higher tax rates will adversely affect incentives to work and
produce, thus, reducing the size of the tax base (domestic output
and income) to the extent that tax revenues will decline.
• It follows that if tax rates are above m, reductions in tax rates will
produce increases in tax revenues.
• At point n tax rates are so high that production is discouraged to
the extent that tax revenues are below maximum at m.
• If the economy is at n, then lower tax rates can either increase
tax revenues or leave them unchanged.
• For example, lowering tax rate point n to point p would not
change the economy’s collection of tax revenues as before.
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Reasoning behind the Laffer curve
• Laffer’s reasoning was that lower tax rates stimulate incentives to work,
save and invest, innovate, and accept business risks, thus triggering an
expansion of real output and income (enlarged tax base).
• That enlarged tax base sustains tax revenues even though tax rates are
lowered.  
• Also, when taxes are lowered, tax avoidance (which is legal) and tax
evasion (which is illegal) decline.
• High marginal tax rates prompt taxpayers to avoid taxes through various
tax shelters such as buying of bonds on which the interest earned is tax-
free.
• High tax rates also encourage some taxpayers to conceal income from the
Internal Revenue Collectors (such as Malawi Revenue Authority – MRA).
• Lower tax rates reduce the inclination to engage in either tax avoidance or
tax evasion.
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 4.3.4 Criticisms of the Laffer curve
• The Laffer curve and its supply-side implications have been subject to severe
criticism. Most notable criticisms include the following.
• (1) Taxes, Incentives and Time
• A basic criticism relates to the degree to which economic incentives are
sensitive to changes in tax rates.
• Skeptics point that the impact of a tax cut on incentives is small, of
uncertain direction, and relatively slow to emerge.
• For example, with respect to work incentives, decreases in tax rates lead
some people to work more as they get enticed by higher after-tax income,
thereby substituting work for leisure because the opportunity cost of
leisure has increased.
• On the other hand, higher after-tax income may lead others to work less
because the higher after-tax income enables them to “buy more leisure”.
• With tax cut, they can work fewer hours and earn the same level of
after-tax income as before.
39
Criticisms of the Laffer curve
• (2) Inflation
• It is most likely that the demand-side effects of a tax cut far exceed
the supply-side effects.
• Thus, tax cuts undertaken when the economy is at or near full-
employment level of output may produce increases in
aggregate demand (AD) and that may overwhelm any increase
in aggregate supply (AS).
• Demand-pull inflation is the likely result.

40
Criticisms of the Laffer curve

• (3) Position on the curve

• Skeptics also say that the Laffer curve is merely a logical proposition
and assert that there must be some level of tax rates between 0 and
100% at which tax revenues will be at their maximum.
• The issue of where a particular economy is located on its Laffer
curve is an empirical question (it needs research verification).
• If we assume that the economy is at point n in Figure 4.9, then tax cuts
will increase tax revenues.
• But critics say that the economy’s location on the Laffer curve is
undocumented and unknown.
• If the economy is at any point below m on the Laffer curve, then tax
reductions will reduce tax revenues and possibly create budget deficits.

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Key Questions
Q1. Mention 4 major factors that can cause aggregate supply shocks in an agro-based
economy. [4 marks]

Q2. Suppose you save K85,000 with a commercial bank that offers an interest rate of
7% per annum and charges a marginal tax rate of 20%.
(a) How much would you receive at the end of 3 years? [5 marks]
(b) What would be the real interest rate that you get? [2 marks]

Q3. Suppose the government misjudges the natural rate of unemployment (NRU) to
be much higher than it actually is, and thus undertakes expansionary fiscal and
monetary policies to try to achieve the lower rate.
(a) Use the concept of the short-run Phillips Curve to explain why these policies
might at first succeed. [5 marks]
(b) Use the concept of the long-run Phillips Curve to explain the long-run outcome
of these policies. [5 marks]

Q4. How does the Laffer Curve relate to supply-side economics? [2 marks]

Q5. Why is determining the economy’s location on the Laffer Curve so important in
assessing tax policy? [2marks]
42
References

• Dornbush, R., Stanley Fisher and Richard Startz (2004).

Macroeconomics, 9th Edition (International Edition), McGraw-Hill
Publishing Company, New York, USA. Chapter 6.

• McConnell, R.C. and Stanley L. Brue (2002). Economics: Principles,

Problems, and Policies, 15th Edition, McGraw-Hill Companies Inc.
New York, USA, Chapter 16.

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