1. Copyright 2008 The McGraw-Hill Companies 15-1 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show 15 Extending the Analysis of Aggregate Supply

2. Copyright 2008 The McGraw-Hill Companies 15-2 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Chapter Objectives The Relationship Between Short-Run Aggregate Supply and Long-Run Aggregate Supply Applying the Extended AD-AS Model to Inflation, Recessions, and Unemployment The Short-Run Tradeoff Between Inflation and Unemployment (Phillips Curve) Why There is No Long-Run Tradeoff Between Inflation and Unemployment Relationship Between Tax Rates, Tax Revenues, and Aggregate Supply

3. Copyright 2008 The McGraw-Hill Companies 15-3 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show From Short Run To Long Run Short Run-a period in which nominal wages do not respond to price level changes –Workers have not made adjustments to their supply and wage demands due to changes in inflation/deflation impacting their real wages –Fixed wage contracts prevent immediate changes to wages to reflect changes in inflation/deflation Long Run-Once contracts have expired and nominal wage adjustments have been made –In LR- nominal wages are fully responsive to changes in price level

4. Copyright 2008 The McGraw-Hill Companies 15-4 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Short Run Aggregate Supply –Firms make nominal wage decisions based on price level persisting at full employment output –When changes occur in P/L, higher prices can be supplied which increase firms profits –Higher profits supply greater output, economy moves from a1 to a2 on aggregate supply, pushing to beyond full employment, causing NRU to decline –Declines in P/L, mean firms are getting lower prices for their supply, with nominal wages staying constant in SR, revenues and profits fall. Firms reduce output, reduce employment. Now unemployment is greater than NRU. QfQf Q2Q2 Q3Q3 P3P3 P1P1 P2P2 AS 1 Real Domestic Output Short-Run Aggregate Supply a1a1 a2a2 a3a3 Price Level

5. Copyright 2008 The McGraw-Hill Companies 15-5 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show 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

6. Copyright 2008 The McGraw-Hill Companies 15-6 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Long Run Aggregate Supply In the LR, nominal wages are fully responsive to changes in price level –Economy initially at a1, employees respond to changes in price level, demand higher nominal wages to accommodate change. Moving to a2. –Because wages (input) increase, AS shifts to the left. –The leftward shift in SRAS now reflects the higher price level. Real output shifts back to full employment level, restoring NRU. –When P/L drops, opposite occurs. Output declines to a3 due to decline in profits until nominal wages can reflect lower price levels. –Lower nominal wages shift SRAS to the right, returning to full employment.

7. Copyright 2008 The McGraw-Hill Companies 15-7 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show From Short Run To Long Run Real Domestic Output Equilibrium in the Extended AD-AS Model Price Level P1P1 QfQf a AS 1 AS LR AD 1 G 15.1

8. Copyright 2008 The McGraw-Hill Companies 15-8 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show LR Equilibrium In the SR-equilibrium occurs wherever the AD and AS intersect. This can be at any output level, causing negative or positive GDP gaps. But in the LR equilibrium, full employment is restored where AD1, LRAS and AS1 intersect.

9. Copyright 2008 The McGraw-Hill Companies 15-9 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show From Short Run To Long Run Real Domestic Output Demand-Pull Inflation in the Extended AD-AS Model Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 b c P2P2 P3P3

10. Copyright 2008 The McGraw-Hill Companies 15-10 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show LR Demand Pull Inflation D-P Inflation occurs when an increase in demand pulls up the price level. However in the LR-nominal wages catch up with P/L and SR supply shifts to the left. Effects: –Increase in price level –Increase in real output –Positive GDP gap Result: –Leftward shift of SR supply back to LR supply at full employment equilibrium –So in the LR Demand Pull only –ExampleExample

11. Copyright 2008 The McGraw-Hill Companies 15-11 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show From Short Run To Long Run Real Domestic Output Cost-Push Inflation in the Extended AD-AS Model 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…

12. Copyright 2008 The McGraw-Hill Companies 15-12 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Cost-Push Inflation Occurs when factors increase the cost of production at each price level, shifting AS to the left and rising equilibrium P/L. –Not a response but initiating cause of increase in P/L. Policy dilemmas: –Negative GDP has occurred. An AD policy to shift AD to the right will increase employment but increase P/L again. –If policymakers do not act with AD, instead allow cost-push recession run its course. Widespread layoffs, plant shutdowns, and business failures occur –At some point demand for oil will decline causing nominal wages and oil prices to decline, initial SR supply shift will reverse. –ExampleExample –Example 2Example 2

13. Copyright 2008 The McGraw-Hill Companies 15-13 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show From Short Run To Long Run Real Domestic Output Recession in the Extended AD-AS Model Price Level P1P1 QfQf a AS 1 AS LR AD 1 AD 2 AS 2 b c P2P2 P3P3 Q1Q1

14. Copyright 2008 The McGraw-Hill Companies 15-14 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show The Inflation-Unemployment Relationship Both low unemployment and low inflation are major key economic goals –Economists are interested in if the two are compatible or conflicting economic goals In extended ADAS 3 significant generalizations relate: 1.Under normal circumstances, there is a trade-off between rate of inflation and rate of unemployment 2.Aggregate supply shocks can cause both high rate of inflation and rate of unemployment 3.There is no significant trade-off between inflation and unemployment in the long run

15. Copyright 2008 The McGraw-Hill Companies 15-15 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Unemployment Rate (Percent) Annual Rate of Inflation (Percent) Unemployment Rate (Percent) The Inflation-Unemployment Relationship The Phillips Curve-demonstrates the SR tradeoff between inflation and unemployment –Inverse Relationship- the higher the inflation rate the lower the unemployment rate and the lower the inflation rate the higher unemloyment 69 68 67 66 65 64 63 62 61 ConceptEmpirical Data Data for the 1960s O 15.1

16. Copyright 2008 The McGraw-Hill Companies 15-16 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show The Inflation-Unemployment Relationship The Short-Run Effect of Changes on Real Output and the Price Level Real Domestic Output Price Level 0 P0P0 P1P1 P2P2 P3P3 Q0Q0 Q1Q1 Q2Q2 Q3Q3 AD 0 AD 1 AD 2 AD 3 AS

17. Copyright 2008 The McGraw-Hill Companies 15-17 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show SR Aggregate Supply curve As AD moves to the right along the SR supply curve, from increases in expenditures, GDP expands causing a decrease in unemployment but an increase in higher price levels. Conclusion- assuming SR AS stays constant, high rates of inflation are accompanied with low rates of unemployment and reverse. Policy: Full employment could not be achieved without inflation –Expansionary fiscal and monetary policy which boosted AD would lower unemployment but increase inflation –Contractionary fiscal and monetary policy restricting AD would lower inflation but increase unemployment rate and decrease production

18. Copyright 2008 The McGraw-Hill Companies 15-18 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show The Inflation-Unemployment Relationship Adverse Supply Shocks and the Phillips Curve –Stagflation occurs when inflation and unemployment rise simultaneously Adverse Aggregate Supply Shocks can cause both high rates of inflation and unemployment –OPEC Oil Price Shock of the 1970’s Extreme shifts left of AS distorted the relationship between IR and UR The Cost-Push model increases the prices level and reduces real output Causing the Philip’s curve to shift to the right –Stagflation’s Demise in the 1980’s After recession of 1981-82 variety of actions shifted AS back to the right Restrictive monetary policy to lower inflation rates, lower nominal wages accepted, price increases slowed, deregulation of airline and trucking industries, decline OPEC’s monopoly power

19. Copyright 2008 The McGraw-Hill Companies 15-19 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show The Inflation-Unemployment Relationship Long-Run Phillips Curve- –no LR relationship between inflation-employment Short-Run Phillips Curve –When increases in AD allow firms to gain higher product prices from inflation, profits increase. Firms respond by hiring more workers and increase output. This causes a movement up the SR Philip’s curve –When AD decreases, firms profits decrease due to the less profits due to disinflation. Firms respond by laying-off employees and reduce output This causes a movement down the SR Phillip’s curve When the actual rate of inflation is higher than expected, profits temporarily rise and unemployment temporarily falls.

20. Copyright 2008 The McGraw-Hill Companies 15-20 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show The Long-Run Vertical Phillips Curve implies that at NRU, the rate of inflation is static Disinflation vs. Inflation 3456 0 3 6 9 12 15 Annual Rate of Inflation (Percent) Unemployment Rate (Percent) PC LR PC 3 PC 2 PC 1 a1a1 b1b1 a2a2 a3a3 b2b2 b3b3 c3c3 c2c2

21. Copyright 2008 The McGraw-Hill Companies 15-21 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Taxation and Aggregate Supply Supply-Side Economics- stress that changes in AS are an active force in determining the levels of inflation, employment and economic growth Government policies can either impede or promote rightward shifts of SR-LR supply curve Key policy-taxation Taxes diminish after-tax rewards of employees and producers reducing the attractiveness of work, saving and investing Tax Rate (Percent) Tax Revenue (Dollars) 100 m 0 n l m Laffer Curve Maximum Tax Revenue

22. Copyright 2008 The McGraw-Hill Companies 15-22 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Taxation and Aggregate Supply Tax Incentives to Work- –The lower the marginal tax rates on earned incomes induce more work, therefore increasing aggregate inputs of labor. –Lower marginal tax rates make leisure more expensive and work more attractive Tax Incentives to Save and Invest –If saving rate is 8% on $10,000 but income tax rate is 40% the incentive to save versus spend is lowered due to the lower rate of return after taxes. $10,000 x 8% = $800 $10,000 x 40% = $4000 after-tax income of $6,000 Interest earned on $6,000 = $480 –Because saving is a precursor to investing, these economists say a critical determinant of investment is after tax rate of return

23. Copyright 2008 The McGraw-Hill Companies 15-23 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Taxation and Aggregate Supply The Laffer Curve Reductions in marginal tax rates increase the nation’s AS and leave the nation’s tax revenue unchanged or even enlarged. Curve depicts the relationship between tax rate and tax revenue. Tax revenues decline beyond some point because higher tax rates discourage economic activity causing shrunken tax base Taxation and Aggregate Supply Tax Rate (Percent) Tax Revenue (Dollars) 100 m 0 n l m Laffer Curve Maximum Tax Revenue

24. Copyright 2008 The McGraw-Hill Companies 15-24 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Rationale for lower tax rates: Incentive to work, save, invest, innovate, and accept business risks thus triggering expansion of real output When taxes are lowered, tax avoidance and tax evasion is reduced decline reducing the incentive to conceal income from IRS through tax shelters Taxation and Aggregate Supply Tax Rate (Percent) Tax Revenue (Dollars) 100 m 0 n l m Laffer Curve Maximum Tax Revenue

25. Copyright 2008 The McGraw-Hill Companies 15-25 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Criticisms of the Laffer Curve Taxes, incentives and Time –Lower tax rates increase incentive to work –But may then increase after-tax income increasing the incentive to buy more leisure Inflation or higher real interest rates –Most economists agree that demand-side tax cuts have more immediate impact on AD increasing inflation which would overwhelm any shift in supply-side tax cuts. –Which would result in contractionary monetary policy which would increase interest rates and investment would decline. Position on the curve –What is the tax rate on the curve that would decline tax revenue?

26. Copyright 2008 The McGraw-Hill Companies 15-26 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Tax Cuts for Whom? 10 People Have Breakfast Together for $100 Charges are Divided in the Way Americans Pay Taxes 4 Poorest Pay Nothing, Fifth Pays $1, Sixth Pays $3, Seventh Pays $7, Eighth Pays $12, Ninth Pays $18, Tenth the Richest Pays $59 Works Fine Until Price is Cut by $20 – How to Divide the Cut? Last Word A Supply-Side Anecdote

27. Copyright 2008 The McGraw-Hill Companies 15-27 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Tax Cuts for Whom? $20 Divided by 6 = $3.33 Resulting in Fifth and Sixth Being Paid to Eat Breakfast Cook Suggests Dividing Proportionate to Price Paid by Each Results in First 5 Paying Nothing, Sixth $2, Seventh $5, Eighth $9, Ninth $12, and Tenth Pays $52 Each of the Paying 6 are Better Off Than Before Last Word A Supply-Side Anecdote

28. Copyright 2008 The McGraw-Hill Companies 15-28 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Tax Cuts for Whom? Conflict Erupts Over Who Got How Much Relief – The Majority Going to the Richest When Confronted the Richest Diner Didn’t Come the Next Day. Surprise – They were $52 Short Without the Richest Payer Last Word A Supply-Side Anecdote

29. Copyright 2008 The McGraw-Hill Companies 15-29 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Tax Cuts for Whom? Morals: People Who Pay the Most Taxes Reap the Most Benefit From Tax Cuts Redistributing Tax Reductions at the Expense of those Paying the Highest Taxes May Produce Unintended Consequences! Last Word A Supply-Side Anecdote

30. Copyright 2008 The McGraw-Hill Companies 15-30 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Key Terms short run long run Phillips Curve stagflation aggregate supply shocks long-run vertical Phillips Curve disinflation supply-side economics Laffer Curve

31. Copyright 2008 The McGraw-Hill Companies 15-31 From Short- Run to Long- Run Extended AD- AS Model The Inflation- Unemployment Relationship Phillips Curve Taxation and Aggregate Supply The Laffer Curve Last Word Key Terms End Show Next Chapter Preview… Economic Growth