1. Extending the Analysis of16
C H A P T E R
Extending the Analysis of
Aggregate Supply

2. SHORT-RUN AND LONG-RUN
AGGREGATE SUPPLY
Short Run -
Period in which nominal wages (and other input prices) remain
fixed as the price level increases or decreases
Long Run -
Short Run: Wages remain fixed and the price level > or <.
Long Run: Wages respond to changes in price level and either > or <
Period in which nominal wages are fully responsive to previous changes in the price level

3. SHORT-RUN AGGREGATE SUPPLY
A higher price level increases profits and output moving the economy from a1 to a2
AS1 P2 a2
Price Level P1 a1
With wages constant, higher profits are achieved in the SR. o Q1 Q2
Real domestic output

4. SHORT-RUN AGGREGATE SUPPLY
A lower price level decreases profits and output moving the economy from a1 to a3
AS1 P2 a2
Price Level P1 a1
And conversely, with wages constant (under contract) a lower price level will reduce profit. P3 a3 o Q3 Q1 Q2
Real domestic output

5. LONG RUN AGGREGATE SUPPLY
A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left
ASLR
AS2 b1
AS1 P2 a2 a1
Price Level P1
A SR rise in P results in higher profits. However, in the LR, wages are renegotiated (raised) so that workers can stay up with the > price level.
And the SR supply curve now shifts to the left. o Q1 Q2
Real domestic output

6. LONG RUN AGGREGATE SUPPLY
A lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right
ASLR
AS2 b1
AS1 P2 a2
AS3 a1
Price Level P1
Similarly, a SR decrease in price level will eventually reduce wages in the long run as firms need to reverse the profit reduction caused by the < in PL. P3 a3 c1 o Q3 Q1 Q2
Real domestic output

7. EQUILIBRIUM IN THE EXTENDED AD-AS MODEL
ASLR
AS1
Price Level P1 a
Extended model simply adds the AsLR Q1.
AD1 o Q1
Real domestic output

8. DEMAND-PULL INFLATION
ASLR
AS2
AS1 c P3
Price Level P2 b P1 a
AD2 represents increased spending and driving up the price level and > output in the SR and shifting the AD curve right. i.e. demand-pull inflation.
However, in the LR, wages rise
AD2
AD1 o Q1
Real domestic output

9. COST-PUSH INFLATION Occurs when short-run AS shifts left Price Level o
ASLR
AS2
AS1
Price Level P2 b P1 a
Cost-push, remember, arises from > in cost of productive resources. In this case, cost-push is the cause of the price level increase, i.e. readjustment of wages. Per unit cost of production goes up.
AD1 o Q2 Q1
Real domestic output

10. 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
A dilemma is created for policy makers.
If govt. tries to maintain Yf then inflationary spiral may occur.
If govt. does nothing, a recession will occur.
AD2
AD1 o Q2 Q1
Real domestic output

11. 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

12. 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
One thinks this will happen. What if it takes a long time for wages to be renegotiated?
This is the real controversy of this model. How long will it take the real world to respond with the necessary price and wage adjustments to achieve the above scenario?
AD1 o Q2 Q1
Real domestic output

13. THE INFLATION-UNEMPLOYMENT
RELATIONSHIP
Normally, there is a short-run trade-off between the rate of inflation and the the rate of unemployment
Aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment
There is no significant trade-off over long periods of time
Start of Phillips curve – an analysis of relationship between unemployment and wage inflation. The theory states that the higher the > in the PL the lower the unemployment rate and vice versa; the lower the rate of inflation, the higher the unemployment rate. An inverse relationship
Idea is that an increase in AD will cause PL to > and real output to expand and the reverse for a decrease in AD.
This trade-off between employment (output) and inflation does not occur over long periods of time. In LR Δ’s in wages are readjusted to return output to Yf.
Supply shocks of 1970’s and early 80’s led to stagflation (inflation and unemployment rise simultaneously (combination of stagnation and inflation). i.e. OPEC quadruples prices. Shocks reverberate through the market, diesel, turbine fuel, home heating etc. etc. Hence, higher rates of inflation and higher rates of unemployment resulted – stagflation.
Also, agriculture shortfalls, depreciated dollar, wage increases and declining productivity occurred during this time.

14. Price Level o Real domestic output
EFFECT OF CHANGES IN AGGREGATE DEMAND
ON REAL OUTPUT AND THE PRICE LEVEL
AD0 AS
Price Level P0 o Q0
Real domestic output

15. Price Level o Real domestic output
EFFECT OF CHANGES IN AGGREGATE DEMAND
ON REAL OUTPUT AND THE PRICE LEVEL
AD0
AD1 AS
Price Level P1 P0 o Q0 Q1
Real domestic output

16. Price Level o Real domestic output
EFFECT OF CHANGES IN AGGREGATE DEMAND
ON REAL OUTPUT AND THE PRICE LEVEL
AD0
AD1
AD2 AS
Price Level P2 P1 P0 o Q0 Q1 Q2
Real domestic output

17. Price Level o Real domestic output
EFFECT OF CHANGES IN AGGREGATE DEMAND
ON REAL OUTPUT AND THE PRICE LEVEL
AD0
AD1
AD2
AD3 AS P3
Price Level P2 P1 P0 o Q0 Q1 Q2 Q3
Real domestic output

18. 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)
An inverse relationship exists.
Unemployment rate (percent)

19. GLOBAL PERSPECTIVE 1990 1995 2000 The Misery Index, Selected Nations
Italy
U.K. 15 10 5
Canada
France
U.S.
Germany
Japan
A nations unemployment rate is added to its inflation rate to indicate the level of “discomfort” A bit deceptive:
5% + 5% = 10%
But
2% + 8% = 10% also
Which is more damaging? Are they =
1990
1995
2000
Source: Bureau of Labor Statistics

20. Aggregate-Supply Shocks Short-Run Phillips Curve
THE LONG-RUN PHILLIPS CURVE
Stagflation’s Demise
Aggregate-Supply Shocks
Short-Run Phillips Curve
Long-Run Vertical Phillips Curve
Disinflation
With the Stagflation of the 70’s – 80’s came its demise or return to normalcy.
Wage cuts, give-backs, deregulation of airlines, foreign competition held down cost in key areas, steel, autos, tight money policy to reduce double digit inflation.
All these factors contributed to reducing per unit cost of production and moving the AS rightward. Output expanded and unemployment <.
LR Phillips curve (economy is generally stable at its NRU) – nominal wages catch up and sustain real wage changes needed either > or <. Inflation or disinflation is net result. SR trade-off relationship exists but not in the LR. Wage changes are anticipated in SR and move from nominal to real in LR. Hence, vertical Phillip’s curve exists showing transition from nominal wages to real and either inflation or disinflation.

21. Taxes and Incentives to Work Incentives to Save and Invest
TAXATION AND AGGREGATE SUPPLY
Taxes and Incentives to Work
Incentives to Save and Invest
Supply-Side Economics
Laffer Curve
Argued that tax transfer system, high marginal tax rate negatively affects incentives to work, invest, innovate and assume entrepreneurial risk.
Unemployment, welfare make job holding less of a crisis. Argued that they are structured to discourage work.
Decrease taxes rewards. More incentive to work, greater investment, more people in labor force, less unemployment, increased productivity.
Supply side basically revolves around tax decreases.

22. THE LAFFER CURVE Tax rate (percent) Tax revenue (dollars)
100
Tax rate (percent)
Tax rates increase from 0, tax revenues increase from 0 to some maximum level (m) and then decline.
The decline comes from the disincentive to work, save and invest because excessive tax makes it unworthwhile. The opportunity cost is working becomes negative when tax would be 100%. At what tax rate does the disincentive begin?
Laffer main point was that if tax rates were above the optimal level, lowering them would increase tax revenue collected. Lower rates trigger expansion, income, investment, employment etc. l
Tax revenue (dollars)

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

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

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

26. Chapter Conclusions Taxes, Incentives, and Time Inflation
Criticisms of the Laffer Curve
Taxes, Incentives, and Time
Inflation
Position on the Curve
Impact on incentives to work, save and invest are small
Tax cuts also increase demand, which can fuel inflation. Demand impact exceeds supply impact.
The curve is based on a logical premise. Yet, where is the economy located or should be located isn’t easily determined. Unless you know that, the impact of a tax cut might have little or a great effect on supply.
Chapter Conclusions

27. KEY TERMS short run long run short-run aggregate supply curve
long-run aggregate supply curve
Phillips Curve
stagflation
aggregate supply shocks
long-run vertical Phillips curve
disinflation
supply-side economics
Laffer Curve
Copyright McGraw-Hill/Irwin, 2002
BACK
END

28. Up next...
Economic Growth and
the New Economy
Chapter 17