Chapter 18 Extending the Analysis of Aggregate Supply Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

18-2 From Short Run to Long Run Short run Input prices inflexible Upsloping aggregate supply Long run Input prices fully flexible Vertical aggregate supply The transition? LO1

18-3 From Short Run to Long Run Production above potential output: High demand for inputs Input prices rise Short run aggregate supply shifts left Return to potential output Production below potential output Graphical examples… LO1

18-4 From Short Run to Long Run P3P3 P1P1 P2P2 P3P3 P1P1 P2P2 Real Domestic Output QfQf Short-Run Aggregate Supply Long-Run Aggregate Supply a1a1 a2a2 a3a3 b1b1 c1c1 Price Level AS 3 AS 2 AS 1 AS LR QfQf Q2Q2 Q3Q3 AS 1 a1a1 a2a2 a3a3 LO1

18-5 From Short Run to Long Run Real Domestic Output Long Run Equilibrium Price Level P1P1 QfQf a AS 1 AS LR AD 1 LO1

18-6 Extended AD-AS Model Real Domestic Output Demand-Pull Inflation Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 c b P2P2 P3P3 Q2Q2 LO2

18-7 Extended AD-AS Model Real Domestic Output Cost-Push Inflation Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 b c P2P2 P3P3 Q2Q2 LO2

18-8 Extended AD-AS Model Real Domestic Output Recession Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 b c P2P2 P3P3 Q1Q1 LO2

18-9 Extended AD-AS Model Explaining ongoing inflation Ongoing economic growth shifts aggregate supply Ongoing increases in money supply shift aggregate demand Small positive rate of inflation LO2

18-10 Price Level Real GDP Capital Goods Consumer Goods Productions Possibilities Long Run Aggregate Supply Increase in production possibilities Increase in long-run aggregate supply LO2 Economic Growth, Ongoing Inflation

18-11 P1P1 P2P2 Q2Q2 Q1Q1 0 Price level Real GDP AS LR1 AS LR2 AS 1 AS 2 AD 1 AD 2 U.S. Growth LO2

18-12 Inflation and Unemployment Low inflation and low unemployment rates Fed’s major goals Compatible or conflicting? Short-run tradeoff Aggregate supply shocks cause both rates to rise No long-run tradeoff LO3

18-13 The Phillips Curve Real Domestic Output Price Level 0 P0P0 P1P1 P2P2 P3P3 Q0Q0 Q1Q1 Q2Q2 Q3Q3 AD 0 AD 1 AD 2 AD 3 AS LO3

18-14 Unemployment Rate (Percent) Annual Rate of Inflation (Percent) Unemployment Rate (Percent) Demonstrates short-run tradeoff between inflation and unemployment ConceptEmpirical Data Data for the 1960s The Phillips Curve LO3

18-15 The Phillips Curve 1960s economists believed in stable, predictable tradeoff Phillips curve shifts over time Adverse supply shocks 1970s OPEC oil price shock Stagflation Stagflation’s demise 1980s LO3

18-16 The Phillips Curve No long-run tradeoff between inflation and unemployment Short-run Phillips curve Role of expected inflation Long-run vertical Phillips curve Disinflation LO4

18-17 The Phillips Curve LO Annual rate of inflation (percent) Unemployment rate (percent)

18-18 The Phillips Curve The Misery Index, Selected Nations, LO4

18-19 The Long-Run Phillips Curve Annual Rate of Inflation (Percent) Unemployment Rate (Percent) PC LR PC 3 PC 2 PC 1 a1a1 b1b1 a2a2 a3a3 b2b2 b3b3 c3c3 c2c2 LO4

18-20 Taxes and Aggregate Supply Supply-side economics Tax and incentives to work Incentives to save and invest The Laffer curve Tax Rate (Percent) Tax Revenue (Dollars) 100 m 0 n l m Laffer Curve Maximum Tax Revenue LO5

18-21 Taxes and Aggregate Supply Criticisms of the Laffer curve Taxes, incentives, and time Inflation or higher real interest rates Position on the curve Rebuttal and evaluation LO5

18-22 Taxes and Real GDP New findings suggest tax increases reduce real GDP (Romer and Romer, 2008) Positive output shocks raise tax revenues Difficult to separate the effects of tax changes from other effects Investment falls sharply in response to tax changes LO5