Extending the Analysis of Aggregate Supply Chapter 35 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Relationship between short-run and long-run aggregate supply Applying the “extended” AD-AS model The Phillips curve No long-run tradeoff between inflation and unemployment Taxes and aggregate supply 35-2

From Short Run to Long Run Short run –Input prices inflexible –Upward sloping aggregate supply Long run –Input prices fully flexible –Vertical aggregate supply The transition? 35-3

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… 35-4

From Short Run to Long Run QfQf Q2Q2 Q3Q3 P3P3 P1P1 P2P2 P3P3 P1P1 P2P2 AS 1 Real Domestic Output QfQf Short-Run Aggregate Supply Long-Run Aggregate Supply a1a1 a2a2 a3a3 a1a1 a2a2 a3a3 b1b1 c1c1 Price Level AS 3 AS 2 AS 1 AS LR 35-5

Extended AD-AS Model Real Domestic Output Long Run Equilibrium Price Level P1P1 QfQf a AS 1 AS LR AD

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 b c P2P2 P3P3 Q2Q2 35-7

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 If government counters recession with spending… If government ignores recession… Q2Q2 35-8

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 35-9

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 35-10

Inflation and Unemployment Low inflation and unemployment –Fed’s major goals –Compatible or conflicting? Short-run tradeoff Supply shocks cause both rates to rise No long-run tradeoff 35-11

Unemployment Rate (Percent) Annual Rate of Inflation (Percent) Unemployment Rate (Percent) The Phillips Curve Demonstrates short-run tradeoff between inflation and unemployment ConceptEmpirical Data Data for the 1960s 35-12

Underlying rationale of 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 The Phillips Curve 35-13

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 35-14

No long-run tradeoff between inflation and unemployment Short-run Phillips curve –Role of expected inflation Long-run vertical Phillips curve Disinflation The Phillips Curve 35-15

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 c2c

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 35-17

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 35-18

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 effects of tax changes from other effects Investment falls sharply in response to tax changes 35-19

Key Terms short run long run Phillips Curve stagflation aggregate supply shocks long-run vertical Phillips Curve disinflation supply-side economics Laffer Curve 35-20

Next Chapter Preview… Current Issues in Macro Theory and Policy 35-21