Extending the Analysis of 16 C H A P T E R Extending the Analysis of Aggregate Supply

SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY Short Run - Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Long Run - Short Run: Wages remain fixed and the price level > or <. Long Run: Wages respond to changes in price level and either > or < Period in which nominal wages are fully responsive to previous changes in the price level

SHORT-RUN AGGREGATE SUPPLY A higher price level increases profits and output moving the economy from a1 to a2 AS1 P2 a2 Price Level P1 a1 With wages constant, higher profits are achieved in the SR. o Q1 Q2 Real domestic output

SHORT-RUN AGGREGATE SUPPLY A lower price level decreases profits and output moving the economy from a1 to a3 AS1 P2 a2 Price Level P1 a1 And conversely, with wages constant (under contract) a lower price level will reduce profit. P3 a3 o Q3 Q1 Q2 Real domestic output

LONG RUN AGGREGATE SUPPLY A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left ASLR AS2 b1 AS1 P2 a2 a1 Price Level P1 A SR rise in P results in higher profits. However, in the LR, wages are renegotiated (raised) so that workers can stay up with the > price level. And the SR supply curve now shifts to the left. o Q1 Q2 Real domestic output

LONG RUN AGGREGATE SUPPLY A lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right ASLR AS2 b1 AS1 P2 a2 AS3 a1 Price Level P1 Similarly, a SR decrease in price level will eventually reduce wages in the long run as firms need to reverse the profit reduction caused by the < in PL. P3 a3 c1 o Q3 Q1 Q2 Real domestic output

EQUILIBRIUM IN THE EXTENDED AD-AS MODEL ASLR AS1 Price Level P1 a Extended model simply adds the AsLR curve @ Q1. AD1 o Q1 Real domestic output

DEMAND-PULL INFLATION ASLR AS2 AS1 c P3 Price Level P2 b P1 a AD2 represents increased spending and driving up the price level and > output in the SR and shifting the AD curve right. i.e. demand-pull inflation. However, in the LR, wages rise AD2 AD1 o Q1 Real domestic output

COST-PUSH INFLATION Occurs when short-run AS shifts left Price Level o ASLR AS2 AS1 Price Level P2 b P1 a Cost-push, remember, arises from > in cost of productive resources. In this case, cost-push is the cause of the price level increase, i.e. readjustment of wages. Per unit cost of production goes up. AD1 o Q2 Q1 Real domestic output

COST-PUSH INFLATION Even higher price levels Government response with increased AD ASLR AS2 AS1 Even higher price levels c P3 Price Level P2 b P1 a A dilemma is created for policy makers. If govt. tries to maintain Yf then inflationary spiral may occur. If govt. does nothing, a recession will occur. AD2 AD1 o Q2 Q1 Real domestic output

COST-PUSH INFLATION If government allows a recession to occur ASLR AS2 AS1 Price Level P2 b P1 a AD1 o Q2 Q1 Real domestic output

COST-PUSH INFLATION If government allows a recession to occur Nominal ASLR AS2 AS1 Nominal wages fall & AS returns to its original location Price Level P2 b P1 a One thinks this will happen. What if it takes a long time for wages to be renegotiated? This is the real controversy of this model. How long will it take the real world to respond with the necessary price and wage adjustments to achieve the above scenario? AD1 o Q2 Q1 Real domestic output

THE INFLATION-UNEMPLOYMENT RELATIONSHIP Normally, there is a short-run trade-off between the rate of inflation and the the rate of unemployment Aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment There is no significant trade-off over long periods of time Start of Phillips curve – an analysis of relationship between unemployment and wage inflation. The theory states that the higher the > in the PL the lower the unemployment rate and vice versa; the lower the rate of inflation, the higher the unemployment rate. An inverse relationship Idea is that an increase in AD will cause PL to > and real output to expand and the reverse for a decrease in AD. This trade-off between employment (output) and inflation does not occur over long periods of time. In LR Δ’s in wages are readjusted to return output to Yf. Supply shocks of 1970’s and early 80’s led to stagflation (inflation and unemployment rise simultaneously (combination of stagnation and inflation). i.e. OPEC quadruples prices. Shocks reverberate through the market, diesel, turbine fuel, home heating etc. etc. Hence, higher rates of inflation and higher rates of unemployment resulted – stagflation. Also, agriculture shortfalls, depreciated dollar, wage increases and declining productivity occurred during this time.

Price Level o Real domestic output EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL AD0 AS Price Level P0 o Q0 Real domestic output

Price Level o Real domestic output EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL AD0 AD1 AS Price Level P1 P0 o Q0 Q1 Real domestic output

Price Level o Real domestic output EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL AD0 AD1 AD2 AS Price Level P2 P1 P0 o Q0 Q1 Q2 Real domestic output

Price Level o Real domestic output EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL AD0 AD1 AD2 AD3 AS P3 Price Level P2 P1 P0 o Q0 Q1 Q2 Q3 Real domestic output

Annual rate of inflation Unemployment rate (percent) THE PHILLIPS CURVE CONCEPT 7 6 5 4 3 2 1 As inflation declines... Unemployment increases Annual rate of inflation (percent) An inverse relationship exists. 1 2 3 4 5 6 7 Unemployment rate (percent)

GLOBAL PERSPECTIVE 1990 1995 2000 The Misery Index, Selected Nations 1990 - 2000 Italy U.K. 15 10 5 Canada France U.S. Germany Japan A nations unemployment rate is added to its inflation rate to indicate the level of “discomfort” A bit deceptive: 5% + 5% = 10% But 2% + 8% = 10% also Which is more damaging? Are they = 1990 1995 2000 Source: Bureau of Labor Statistics

Aggregate-Supply Shocks Short-Run Phillips Curve THE LONG-RUN PHILLIPS CURVE Stagflation’s Demise Aggregate-Supply Shocks Short-Run Phillips Curve Long-Run Vertical Phillips Curve Disinflation With the Stagflation of the 70’s – 80’s came its demise or return to normalcy. Wage cuts, give-backs, deregulation of airlines, foreign competition held down cost in key areas, steel, autos, tight money policy to reduce double digit inflation. All these factors contributed to reducing per unit cost of production and moving the AS rightward. Output expanded and unemployment <. LR Phillips curve (economy is generally stable at its NRU) – nominal wages catch up and sustain real wage changes needed either > or <. Inflation or disinflation is net result. SR trade-off relationship exists but not in the LR. Wage changes are anticipated in SR and move from nominal to real in LR. Hence, vertical Phillip’s curve exists showing transition from nominal wages to real and either inflation or disinflation.

Taxes and Incentives to Work Incentives to Save and Invest TAXATION AND AGGREGATE SUPPLY Taxes and Incentives to Work Incentives to Save and Invest Supply-Side Economics Laffer Curve Argued that tax transfer system, high marginal tax rate negatively affects incentives to work, invest, innovate and assume entrepreneurial risk. Unemployment, welfare make job holding less of a crisis. Argued that they are structured to discourage work. Decrease taxes rewards. More incentive to work, greater investment, more people in labor force, less unemployment, increased productivity. Supply side basically revolves around tax decreases.

THE LAFFER CURVE Tax rate (percent) Tax revenue (dollars) 100 Tax rate (percent) Tax rates increase from 0, tax revenues increase from 0 to some maximum level (m) and then decline. The decline comes from the disincentive to work, save and invest because excessive tax makes it unworthwhile. The opportunity cost is working becomes negative when tax would be 100%. At what tax rate does the disincentive begin? Laffer main point was that if tax rates were above the optimal level, lowering them would increase tax revenue collected. Lower rates trigger expansion, income, investment, employment etc. l Tax revenue (dollars)

THE LAFFER CURVE 100 Tax rate (percent) m l Tax revenue (dollars)

THE LAFFER CURVE 100 n Tax rate (percent) m l Tax revenue (dollars)

THE LAFFER CURVE Maximum Tax Revenue Tax rate (percent) 100 n Tax rate (percent) m m Maximum Tax Revenue l Tax revenue (dollars)

Chapter Conclusions Taxes, Incentives, and Time Inflation Criticisms of the Laffer Curve Taxes, Incentives, and Time Inflation Position on the Curve Impact on incentives to work, save and invest are small Tax cuts also increase demand, which can fuel inflation. Demand impact exceeds supply impact. The curve is based on a logical premise. Yet, where is the economy located or should be located isn’t easily determined. Unless you know that, the impact of a tax cut might have little or a great effect on supply. Chapter Conclusions

KEY TERMS short run long run short-run aggregate supply curve long-run aggregate supply curve Phillips Curve stagflation aggregate supply shocks long-run vertical Phillips curve disinflation supply-side economics Laffer Curve Copyright McGraw-Hill/Irwin, 2002 BACK END

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