1. Extending the Analysis of Aggregate Supply
We will analyze how aggregate demand and supply change as we move from the short run to the long run. We will apply this model to cost-push inflation, demand-pull inflation, and economic growth. The Phillips curve is introduced along with the impact of taxes and aggregate supply and taxes and economic growth.
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. Loanable Funds Market Is an interest rate of 50% good or bad?
Bad for borrowers but good for lenders
The loanable funds market is the private sector supply and demand of loans.
This market shows the effect on REAL INTEREST RATE
Demand- Inverse relationship between real interest rate and quantity loans demanded
Supply- Direct relationship between real interest rate and quantity loans supplied
This is NOT the same as the money market. (supply is not vertical)

3. Loanable Funds Market SLenders re DBorrowers QLoans
At the equilibrium real interest rate the amount borrowers want to borrow equals the amount lenders want to lend.
Real Interest Rate
SLenders re
DBorrowers
QLoans
Quantity of Loans 3

4. Loanable Funds Market Example: The Gov’t increases deficit spending?
Government borrows from private sector
Increasing the demand for loans
Real Interest Rate
SLenders
Real interest rates increase causing
crowding out!! r1 re D1
DBorrowers
QLoans Q1
Quantity of Loans 4

5. Loanable Funds Market Demand Shifters Supply Shifters
Changes in perceived business opportunities
Changes in government borrowing
Budget Deficit
Budget Surplus
Changes in private savings behavior
Changes in expected profitability 5

6. 2007B Practice FRQ 6

7. 2007B Practice FRQ 7

8. 2007B Practice FRQ 8

9. Economic Growth, Ongoing Inflation
Productions Possibilities
Long Run Aggregate Supply
Capital Goods
Price Level
Economic growth is illustrated by either an outward shift on the production possibilities curve or a rightward shift in the long run aggregate supply curve. As the curves shift, they will lead to price increases at a new equilibrium level. Prices very rarely decrease in the long run. Why not? The Federal Reserve will increase the money supply to create rightward shifts in the aggregate demand curve.
Consumer Goods
Real GDP
Increase in production possibilities
Increase in long-run aggregate supply
LO2
35-9

10. From Short Run & Long Run AS
Input prices inflexible
Up sloping aggregate supply
Long run
Input prices fully flexible
Vertical aggregate supply
Moving from short-run aggregate supply to a long-run aggregate supply model is a key analytical tool in understanding how the economy adjusts to economic shocks as well as monetary and fiscal policy. While in the short run, input prices tend to be inflexible, meaning they cannot be changed easily. In the long run, all prices are fully flexible. Making the transition from short run to long run will provide much insight into the process.
LO1
35-10

11. U.S. Growth Price level Real GDP ASLR1 ASLR2 AS2 AS1 P2 P1 AD2 AD1 Q1
The whole key to managing inflation is for the Fed to use monetary policy to shift the aggregate demand curve to the right faster than the supply factors of economic growth shift the long-run aggregate supply curve to the right. An economy can withstand mild inflation as long as it is occurring at a slow pace. It is the sudden shifts in the curve that cause economic chaos.
AD1 Q1 Q2
Real GDP
LO2
35-11

12. From Short Run to Long Run
Long Run Equilibrium
ASLR
AS1
Price Level P1 a
Bringing in the aggregate demand curve, we now have a graph with three curves: short run aggregate supply, long run aggregate supply, and aggregate demand (which is the same regardless of short run or long run). All three intersect at the long run outcome, which is the nation’s natural level of unemployment. In the U.S., that is assumed to be between 4-5%.
AD1 Qf
Real Domestic Output
LO1
35-12

13. Price Level o Real domestic output EQUILIBRIUM IN THE
EXTENDED AD-AS MODEL
ASLR
AS1
Price Level P1 a
AD1 o Q1
Real domestic output

14. DEMAND-PULL INFLATION
ASLR
AS2
AS1 c P3
Price Level P2 b P1 a
AD2
AD1 o Q1
Real domestic output

15. COST-PUSH INFLATION (Stagflation)
Occurs when short-run AS shifts left
ASLR
AS2
AS1
Price Level P2 b P1 a
AD1 o Q2 Q1
Real domestic output

16. 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 Q1
Real domestic output

17. COST-PUSH INFLATION If government allows a recession to occur
ASLR
AS2
AS1
Price Level P2 b P1 a
AD1 o Q2 Q1
Real domestic output

18. 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 Q1
Real domestic output

19. Extended AD-AS Model Recession P1 a P2 b Price Level P3 c Q1 Qf
ASLR
AS1
AS2 P1 a P2 b
Price Level P3 c
The most challenging issue to deal with is the effect of recession on the model. In a recession, aggregate demand declines and shifts left, which reduces prices. The economy will be producing less, so the demand for inputs will be low. Eventually nominal wages will drop. Once the wages fall, aggregate supply will decrease, which will decrease prices further. We are back at the long run equilibrium of full-employment, but at a much lower price level.
AD1
AD2 Q1 Qf
Real Domestic Output
LO2
35-19

20. 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
Is it possible to have low inflation and low unemployment at the same time? In the short run, there is a trade off: To achieve low inflation, you will have to tolerate a higher rate of unemployment. However, over the long run, it is possible to have your cake and eat it too, so to speak.
LO3
35-20

21. No long-run tradeoff between inflation and unemployment
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
The third generalization from the Phillips Curve analysis is that there is no long-run tradeoff between inflation and unemployment, meaning you can control inflation without causing an increase in the unemployment rate. In the short run analysis, if the actual inflation rate is higher than expected, profits temporarily rise and the unemployment rate temporarily falls. But this is not a permanent situation. In the long run, workers will demand an increase in nominal wages to reflect the increased demand for workers and higher prices they must pay. This will reduce the temporary profits, and output will decrease, returning unemployment to its natural level. This distinction between the long run Phillips Curve and the short run Phillips Curve also helps to explain disinflation, which is a reduction in the inflation rate from year to year. When the actual rate of inflation is lower than expected, profits temporarily will fall and the unemployment rate will temporarily rise until equilibrium is restored in the long run.
LO4
35-21

22. The Phillips Curve
Demonstrates short-run tradeoff between inflation and unemployment
Concept
Empirical Data
Data for the 1960s
Annual Rate of Inflation (Percent)
Unemployment Rate (Percent)
Unemployment Rate (Percent)
Annual Rate of Inflation (Percent) 69 68 66
The Phillips Curve, named for economist A.W. Phillips, suggests an inverse relationship between the rate of inflation and the rate of unemployment. As we see in these graphs, you end up with a downward sloping curve. Statistics from the 1960s support this concept. 67 65 63 62 64 61
LO3
35-22

23. The Phillips Curve Shows tradeoff between inflation and unemployment.
What happens to inflation and unemployment when AD increase?

24. In general, there is an inverse relationship between unemployment and inflation24

25. 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)
Unemployment rate (percent)

26. Short Run Phillips Curve
When the economy is overheating, there is low unemployment but high inflation
Inflation
When there is a recession, unemployment is high but inflation is low 5%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1%
SRPC 2% 9%
Unemployment 26

27. Short Run Phillips Curve
What happens when AS falls causing stagflation?
Increase in unemployment and inflation
Inflation 5%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC1 1%
SRPC 2% 9%
Unemployment 27

28. Short Run vs. Long Run What happens when AD increases?
What happens in the long run?
Long Run Phillips Curve
Inflation
In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 5% 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC1 1%
SRPC 2% 5% 9%
Unemployment 28

29. Short Run vs. Long Run Long Run Phillips Curve
In the long run there is no tradeoff between inflation and unemployment
Long Run Phillips Curve
Inflation 5%
The LRPC is vertical at the Natural Rate of Unemployment 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9%
Unemployment 29

30. What happens when AD falls? What happens in the long run?
Short Run vs. Long Run
What happens when AD falls?
What happens in the long run?
Long Run
Phillips Curve
Inflation 5%
In the long run wages fall and there is no tradeoff between inflation and unemployment 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1%
SRPC
SRPC1 2% 5% 9%
Unemployment 30

31. AD/AS and the Phillips Curve
Show what happens on both graphs if AD increase
LRPC
Price Level
LRAS
Inflation AS
PLe
AD1 AD
SRPC QY
GDPR UY
Unemployment 31

32. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls?
Price Level
LRAS
LRPC
Inflation AS
PLe AD
SRPC
AD1 QY
GDPR UY
Unemployment 32

33. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC at full employment. What happens when AS falls?
Price Level
LRAS
LRPC
Inflation
AS1 AS
PLe
SRPC1 AD
SRPC QY
GDPR UY
Unemployment 33

34. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up?
Price Level
LRAS
LRPC
Inflation AS
AS1
PLe
SRPC AD
SRPC1 QY
GDPR UY
Unemployment 34

35. SRAS
LRPC
LRAS
Price Level
Inflation
SRPC QY
GDPR UY
Unemployment 35

36. SRAS LRPC LRAS Price Level Inflation PLe AD2 AD SRPC AD3 QY GDPR UY
Unemployment 36

37. AS1 SRAS LRPC LRAS Price Level Inflation AS2 PLe SRPC1 AD SRPC2 SRPCQY
GDPR UY
Unemployment 37

38. AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPRUY
Unemployment 38

39. The Laffer Curve
People will not work and firms will not produce anything if the tax rate is 100%.
People pay no income taxes when the tax rate is 0%.
Hence,
Tax Revenue = 0
If no one works and nothing is produce, the economy generates no income.
Hence,
Tax Revenue = 0
2.5
2.0
Tax Revenue
(in trillions of $)
1.5
1.0
0.5 20 40 60 80
100
tax rate (percent)

40. The Laffer Curve
If tax revenue is 0 when the tax rate is 0% or 100%, there is a tax rate where tax revenues reach a maximum value.
If tax revenue is 0 when the tax rate is 0% or 100%, there is a tax rate where tax revenues reach a maximum value.
This tax rate generates $2.5 trillion in tax revenue.
According to the diagram below, the optimal tax rate is 30%. 30
2.5
2.5
2.0
Tax Revenue
(in trillions of $)
1.5
1.0
0.5 20 40 60 80
100
tax rate (percent)

41. The Laffer Curve If the tax rate is 60%,
If the tax rate is cut to 30%,
tax revenue is $1.7 trillion.
tax revenue increases to $2.5 trillion.
2.5
2.5
2.0
Tax Revenue
(in trillions of $)
1.7
1.5
1.0
0.5 30 20 40 60 60 80
100
tax rate (percent)

42. The Laffer Curve If the tax rate is 30%,
If the tax rate is raised to 60%,
tax revenue is $2.5 trillion.
tax revenue decreases to $1.7 trillion.
2.5
2.5
2.0
Tax Revenue
(in trillions of $)
1.7
1.5
1.0
0.5 30 20 40 60 60 80
100
tax rate (percent)

43. The Laffer Curve
The Laffer Curve also suggests that when tax rates are too “low,” a tax cut lowers tax revenue.
2.5
2.3
2.0
Tax Revenue
(in trillions of $)
1.6
1.5
1.0
0.5 10 20 20 40 60 80
100
tax rate (percent)

44. THE LAFFER CURVE
100
Tax rate (percent) l
Tax revenue (dollars)

45. THE LAFFER CURVE
100
Tax rate (percent) m l
Tax revenue (dollars)

46. THE LAFFER CURVE
100 n
Tax rate (percent) m l
Tax revenue (dollars)

47. THE LAFFER CURVE Maximum Tax Revenue n m m l 100 Tax rate (percent)
Tax revenue (dollars)

48. Taxes and Aggregate Supply
Supply-side economics
Tax incentives to work
Tax incentives to save and invest
The Laffer curve
100 n
Supply-side economists feel that changes in aggregate supply are an active force in determining the levels of inflation, unemployment, and economic growth. They feel the government should use fiscal policy to encourage the desired economic behavior. One tool the government has in its arsenal is taxation. Taxes can be used to encourage people to work, save, and invest. Lower marginal rates can encourage workers to work longer as their after-tax wage increases and makes work more attractive. Lower marginal rates also encourage people to save and invest, as they will be able to keep more of the income off of the investment. The Laffer Curve depicts the relationship between tax rates and tax revenue. It shows that there is a maximum tax rate that will maximize tax revenue. If the tax rate rises above this level, tax revenues actually decline as the higher tax rates discourage economic activity.
Laffer Curve
Tax Rate (Percent) m m
Maximum
Tax Revenue l
Tax Revenue (Dollars)
LO5
35-48