35 Extending the Analysis of Aggregate Supply McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 16

From Short Run to Long Run Short run Wages and other input prices don’t change. Upsloping aggregate supply Long run Wages and other input prices fully flexible Vertical aggregate supply. LO1 35-2

From Short Run to Long Run Production above potential output: Price level increases. Nominal wages eventually rise to maintain real wages (purchasing power). Other input prices rise Short run aggregate supply shifts left because costs are higher. Return to potential output at a higher price level. LO1 35-3

Extended AD-AS Model Real Domestic Output Increased Demand Price Level P1P1 QfQf a AS 1 LRAS AD 1 AD 2 b P2P2 Q2Q2 LO Short Run- Long Run

Price ($) QUANTITY MC D = P = MR Qe Pe Perfectly Competitive Firm in Long-run Equilibrium Q2

Extended AD-AS Model Real Domestic Output Increased Demand Price Level P1P1 QfQf a AS 1 LRAS AD 1 AD 2 AS 2 c b P2P2 P3P3 Q2Q2 LO Short Run- Long Run

From Short Run to Long Run Production below potential output: Price level decreases. Nominal wages eventually fall to maintain real labor costs. Input prices fall. Short run aggregate supply shifts right because costs are lower. Return to potential output at a lower price level. LO1 35-7

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 35-8

Extended AD-AS Model Real Domestic Output Decreased Demand Price Level P1P1 QfQf a AS 1 LRAS AD 1 AD 2 AS 2 b P2P2 Q1Q1 LO Long Run- Short Run

Price ($) QUANTITY MC D = P = MR Qe Pe Perfectly Competitive Firm in Long-run Equilibrium Q2

Extended AD-AS Model Real Domestic Output Decreased Demand Price Level P1P1 QfQf a AS 1 LRAS AD 1 AD 2 AS 2 b c P2P2 P3P3 Q1Q1 LO Long Run- Short Run

From Short Run to Long Run Real Domestic Output So what is it about full employment that keeps bringing everything back here? Price Level P1P1 QfQf a AS 1 AS LR AD 1 LO

From Short Run to Long Run Real Domestic Output It’s the level of employment at which there is neither upward nor downward pressure on wages and input prices. Price Level P1P1 QfQf a AS 1 AS LR AD 1 LO

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 LO

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 LO

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 LO

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 LO

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

P1P1 P2P2 Q2Q2 Q1Q1 0 Price level Real GDP AS LR1 AS LR2 AS 1 AS 2 AD 1 AD 2 U.S. Growth LO

Inflation and Unemployment Low inflation and unemployment Fed’s two major goals Compatible or conflicting? Short-run tradeoff between inflation and unemployment Supply shocks cause both rates to rise No long-run tradeoff LO

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 LO

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 LO

The Phillips Curve LO Annual rate of inflation (percent) Unemployment rate (percent) 35-23

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 LO

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 The Phillips Curve LO

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 LO

The Phillips Curve The Misery Index, Selected Nations, Source: Bureau of Labor Statistics,stats.bls.gov LO

Taxes and Aggregate Supply Supply-side economics Tax incentives to work Tax 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 LO

Taxes and Aggregate Supply Criticisms of the Laffer curve Taxes, incentives, and time Inflation and higher real interest rates Position on the curve Rebuttal and evaluation LO

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 LO