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 - 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 o Qf 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 P3 a3 o Q3 Qf 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 o Qf 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 P3 a3 c1 o Qf Real domestic output

EQUILIBRIUM IN THE EXTENDED AD-AS MODEL ASLR AS1 Price Level P1 a AD1 o Qf Real domestic output

DEMAND-PULL INFLATION ASLR AS2 AS1 c P3 Price Level P2 b P1 a AD2 AD1 o Qf 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 AD1 o Q2 Qf 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 AD2 AD1 o Q2 Qf 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 Qf 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 AD1 o Q2 Qf 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.

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) 1 2 3 4 5 6 7 Unemployment rate (percent)

GLOBAL PERSPECTIVE 1992 1997 2002 The Misery Index, Selected Nations 1992 - 2002 Canada Italy 15 10 5 U.K. France U.S. Germany Japan 1992 1997 2002 Source: Bureau of Labor Statistics

Aggregate-Supply Shocks Stagflation’s Demise Short-Run Phillips Curve THE LONG-RUN PHILLIPS CURVE Aggregate-Supply Shocks Stagflation’s Demise Short-Run Phillips Curve Long-Run Vertical Phillips Curve Disinflation

Supply-Side Economics Taxes and Incentives to Work TAXATION AND AGGREGATE SUPPLY Supply-Side Economics Taxes and Incentives to Work Incentives to Save and Invest Laffer Curve

THE LAFFER CURVE 100 Tax rate (percent) 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)

Taxes, Incentives, and Time Inflation or Higher Interest Rates Criticisms of the Laffer Curve Taxes, Incentives, and Time Inflation or Higher Interest Rates Position on the Curve Rebuttal and Evaluation

aggregate supply shocks long-run vertical Phillips curve disinflation KEY TERMS short run long run Phillips curve stagflation aggregate supply shocks long-run vertical Phillips curve disinflation supply-side economics Laffer curve Copyright McGraw-Hill/Irwin, 2005 BACK END

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