1. 10/22/20141 Long-Run Aggregate Supply and Aggregate Demand Chapter 11

2. 2 Outline From Short Run to Long Run From Short Run to Long Run Long Run Equilibrium in the AD-AS Model Long Run Equilibrium in the AD-AS Model Economic Growth and On-Going Inflation Economic Growth and On-Going Inflation The Inflation-Unemployment Relationship The Inflation-Unemployment Relationship Taxation and AS Taxation and AS

3. 10/22/20143 From Short Run to Long Run Long Run (LR)Short Run (SR) output prices,output prices are flexible, wages, and other input pricesbut wages and other input prices are all flexible.are inflexible. A period in which P P Q($bil) P3P3 AS 1 AS LR P1P1 P2P2 QfQf AS 1 QfQf P2P2 P1P1 P3P3 a1a1 a1a1 The SRAS is upward-sloping.The LRAS is vertical at Qf.

4. 10/22/20144 From Short Run to Long Run Three assumptions about SRAS AS 1 : (1) The initial price level is P 1 ; (2) this price level is expected to persist; (3) the price level can be flexible both upward and downward P P Q($bil) P3P3 AS 1 AS LR P1P1 P2P2 Q3Q3 QfQf Q2Q2 AS 1 AS 3 AS 2 QfQf P2P2 P1P1 P3P3 a1a1 a2a2 a3a3 a1a1 a3a3 a2a2 b1b1 At a 1, the economy operates at full employment, potential output Q f. The price level is P 1. The unemployment rate is u n, the natural rate of unemployment. Now suppose that the price level rises to P 2. In the SR, nominal wages and input prices remain unchanged. Firms incur the same costs. Higher output prices increase their revenues and thus their profits. Firms increase output to Q 2. The economy moves up to point a 2 on AS 1, which slopes upward. The nation’s unemployment rate declines below its natural rate. Vice versa. if the price level falls from P 1 to P 3. In the SR, firms make less profits because lower prices decrease their revenues while they incur the same input costs. Firms decrease output to Q 3. The economy moves down to point a 3 on AS 1. The nation’s unemployment rate rises above its natural rate. In the LR, output prices, wages and input prices are all flexible. If the price level rises from P 1 to P 2, firms increase output in the SR. The economy moves up along AS 1. Wages and input prices also increase, shifting AS 1 to the left to AS 2. The economy moves to point b 1 on LRAS and AS 2. The nation’s unemployment rate rises to its natural rate. The LRAS is vertical at Q f. c1c1 In the LR, output prices, wages and input prices are all flexible. If the price level falls from P 1 to P 3, firms decrease output in the SR. The economy moves down along AS 1. Wages and input prices also decrease, shifting AS 1 to the right to AS 3. The economy moves to point c 1 on LRAS and AS 3. The nation’s unemployment rate falls to its natural rate. Again, the LRAS is vertical at Q f.

5. 10/22/20145 LR Equilibrium in the AD-AS Model Demand-pull inflation in the LR AD-AS model Demand-pull inflation in the LR AD-AS model Cost-push inflation in the LR AD-AS model Cost-push inflation in the LR AD-AS model Recession in the LR AD-AS model Recession in the LR AD-AS model

6. 10/22/20146 LR Equilibrium in the AD-AS Model The LR AD-AS model is a model in which the equilibrium price level and the level of real GDP are determined by the intersection of the AD curve and the LRAS curve. The LR AD-AS model is a model in which the equilibrium price level and the level of real GDP are determined by the intersection of the AD curve and the LRAS curve.

7. 10/22/20147 LR Equilibrium in the AD-AS Model Price Level P (index) Real GDP ($billion) LRASAS 1 AD 1 P1P1 QfQf LR equilibrium occurs where three curves, LRAS, SRAS, and AD, intersect. The economy achieves its LR equilibrium at E 1 and produces full-employment output Q f. E1E1

8. 10/22/20148 Demand-pull inflation in LR AD-AS model Price Level P (index) Real GDP ($billion) LRASAS 1 AD 1 P1P1 QfQf In the SR, an increase in AD from AD 1 to AD 2 causes demand-pull inflation. The price level and real GDP both rise. The economy moves from E 1 to E 2. E1E1 AD 2 P2P2 E2E2 Q2Q2 In the LR, wages and input prices also rise, causing the SRAS curve to shift leftward, from AS 1 to AS 2. Real GDP falls back to its prior level Q f, and the price level rises to P 3. The economy moves from E 2 to E 3. AS 2 E3E3 P3P3

9. 10/22/20149 Cost-push inflation in LR AD-AS model Price Level P (index) Real GDP ($billion) LRASAS 1 AD 1 P1P1 QfQf In the SR, a decrease in AS from AS 1 to AS 2 causes cost-push inflation. The price level rises and real GDP falls. The economy moves from E 1 to E 2. E1E1 AD 2 P2P2 E2E2 Q2Q2 If the government does nothing, in the LR, the reduction in real GDP lowers the demand for inputs. Wages and input prices fall, causing AS to shift back to AS 2. The economy moves from E 1 to E 2 then eventually back to E 1. AS 2 E3E3 P3P3 However, if the government counters the decline in real GDP by increasing AD from AD 1 to AD 2, the price level will rise to P 3. The economy moves from E 1 to E 2 then to E 3.

10. 10/22/201410 Recession in LR AD-AS model Price Level P (index) Real GDP ($billion) LRASAS 2 AD 2 P3P3 QfQf In the SR, a decrease in AD from AD 1 to AD 2 causes a recession. Both the price level and real GDP fall. The economy moves from E 1 to E 2. E3E3 AD 1 P2P2 E2E2 Q2Q2 If the government does nothing, in the LR, the reduction in real GDP lowers the demand for inputs. Wages and input prices fall, causing AS to shift to AS 2. The economy moves from E 1 to E 2 then eventually to E 3. AS 1 E1E1 P1P1

11. 10/22/201411 Summary SituationCauseOutcomes Demand-pull inflation Cost-push inflation Recession AD up AS down AD down Q up (U down) P up Q down (U up) P up Q down (U up) P down Outcomes (Laissez-faire non-intervention policy) AS down AS up Q down (U up) P up (more inflation) Q up (U down) P down Q up (U down) P down (more deflation) Short RunLong Run

12. 10/22/201412 Summary SituationCauseOutcomes Demand-pull inflation Cost-push inflation Recession AD up AS down AD down Q up (U down) P up Q down (U up) P up Q down (U up) P down Outcomes Government intervention AD down AD up Q down (U up) P down Q up (U down) P up (more inflation) Q up (U down) P up Short RunLong Run AD down Q down (U up/higher) P down

13. 10/22/201413 Production possibilities and LRAS Consumer goodsReal GDP Capital goods Price level Originally, the economy’s PPC is AB. The LR aggregate supply is LRAS 1, the full-employment real GDP is Q 1. A B C D LRAS 1 LRAS 2 Q1Q1 Q2Q2 In the LR, supply factors (advances in technology and more and better resources) cause the economy to grow. The PPC shifts to the right to CD. The economy’s LRAS also shifts to the right to LRAS 2, where Q 2 is the new real GDP.

14. 10/22/201414 Economic Growth and On-Going Inflation Price level P Real GDP Q Originally, the economy achieved LR equilibrium at E 1, where LRAS 1, AS 1, and AD 1 cross. The price level is P 1 and the full-employment real GDP Q 1. AD 1 AS 1 LRAS 1 Q1Q1 E1E1 P1P1 Over time, supply factors shift both LRAS and AS to the right. Simultaneously, increases in population and money supply also shifts AD to the right. The economy grows but experiences higher prices or on-going inflation. AD 2 AS 2 E2E2 P2P2 Q2Q2 LRAS 2 Over long periods, any inflation that occurs is the result of the growth of AD.

15. 10/22/201415 The Inflation-Unemployment Relationship SR trade-off: the Phillips curve SR trade-off: the Phillips curve AS shocks and shifts of the Phillips curve AS shocks and shifts of the Phillips curve No LR inflation-unemployment trade-off No LR inflation-unemployment trade-off

16. 10/22/201416 Three important points Under normal circumstances, a SR trade- off exists between the rate of inflation, p (%), and the rate of unemployment, u (%). Under normal circumstances, a SR trade- off exists between the rate of inflation, p (%), and the rate of unemployment, u (%). AS shocks can cause both higher rates of inflation and higher rates of unemployment. AS shocks can cause both higher rates of inflation and higher rates of unemployment. No significant trade-off exists between inflation and unemployment over long periods of time. No significant trade-off exists between inflation and unemployment over long periods of time.

17. 10/22/201417 SR trade-off: the Phillips curve (PC) Qu (%) P p (%) Originally, the economy achieves equilibrium at a. The price level is P 1 and real GDP Q 1, as shown on the left diagram below. At a, the corresponding inflation rate is p 1 and unemployment rate u 1, as shown on the right diagram. PC 1 u2u2 u1u1 AD 1 Q1Q1 a P1P1 AS 1 a p1p1 In the SR, an increase in AD shifts the AD curve to the right to AD 2, causing the price level to rise to P 2, i.e. higher inflation, and real GDP to rise to Q 2, i.e. lower unemployment. The economy moves from a to b on both diagrams. AD 2 b P2P2 b p2p2 In the SR, a decrease in AD shifts the AD curve to the left to AD 3, causing the price level to fall to P 3, i.e. lower inflation, and real GDP to fall to Q 3, i.e. higher unemployment. The economy moves from a to c on both diagrams. AD 3 Q2Q2 c P3P3 p3p3 c Q3Q3 u3u3 The SR Phillips curve PC 1 is drawn by connecting three points a, b, and c. It shows a trade-off between the inflation rate, p(%), and the unemployment rate, u(%). When one rate is higher, the other rate is lower, and vice versa. The SR Phillips curve is derived as a result of shifts in AD.

18. 10/22/201418 AS shocks and shifts of the Phillips curve Qu (%) P p (%) Originally, the economy achieves equilibrium at a. The price level is P 1 and real GDP Q 1, as shown on the left diagram below. At a, the corresponding inflation rate is p 1 and unemployment rate u 1, as shown on the right diagram. Point a is on PC 1. PC 1 u2u2 u1u1 AD 1 Q1Q1 a P1P1 AS 1 a p1p1 In the SR, an increase in AS shifts the AS curve to the right to AS 2, causing the price level to fall to P 2, i.e. lower inflation, and real GDP to rise to Q 2, i.e. lower unemployment. The economy moves from a to b on both diagrams. b P2P2 b p2p2 In the SR, a decrease in AS shifts the AS curve to the left to AS 3, causing the price level to rise to P 3, i.e. higher inflation, and real GDP to fall to Q 3, i.e. higher unemployment. The economy moves from a to c on both diagrams. Q2Q2 c P3P3 p3p3 c Q3Q3 u3u3 Since three points a, b, and c, cannot be on the same SR Phillips curve, it means that the Phillips curve shifts. Shifts/changes in AS cause both inflation and unemployment rates to change in the opposite direction. The SR Phillips curve shifts in opposite directions with a shift in SRAS. AS 3 AS 2 PC 3 PC 2

19. 10/22/201419 No LR inflation-unemployment trade-off Qu(%) P p(%) Originally, the economy is at a on both diagrams. The LR aggregate supply is LRAS, the AD is AD 1 and the SR PC is PC 1.The economy achieves full-employment real GDP Q f, at the natural rate of unemployment u n. P2P2 a LRPCLRAS QfQf unun AD 1 a PC 1 AD 3 P3P3 cc P1P1 PC 3 PC 2 AD 2 b b a’ b’ In the LR, AD increases to AD 2, causing the economy to move from point a to a’ on the right diagram. LR self-adjustment brings the economy to point b on both diagrams, back to Q f and u n again. The process continues. The LR Phillips curve is vertical at the natural rate of unemployment, u n, which corresponds to the full-employment, potential output Q f, from where the LRAS starts.

20. 10/22/201420 Taxation and AS The Laffer curve The Laffer curve Criticisms, rebuttal, and assessment Criticisms, rebuttal, and assessment

21. 10/22/201421 Supply-side economics A view of macroeconomics that emphasizes the role of marginal tax rates and other factors that affect LRAS and therefore affect inflation, unemployment, and economic growth. A view of macroeconomics that emphasizes the role of marginal tax rates and other factors that affect LRAS and therefore affect inflation, unemployment, and economic growth. Marginal tax rates, the rates on extra dollars of income, vary from 10% to 35% in the U.S. Marginal tax rates, the rates on extra dollars of income, vary from 10% to 35% in the U.S.

22. 10/22/201422 Taxation and AS High marginal tax rates reduce people’s incentives to work, save, or invest more. High marginal tax rates reduce people’s incentives to work, save, or invest more. To expand LRAS and economic growth, government should lower marginal tax rates. To expand LRAS and economic growth, government should lower marginal tax rates. Changing marginal tax rates affect government tax revenue. Changing marginal tax rates affect government tax revenue.

23. 10/22/201423 The Laffer curve Tax rate (%) Tax revenue ($) m Maximum tax revenue Low tax rates increase productivity, output, and thus tax revenue High tax rates reduce productivity, output, and thus tax revenue Marginal tax rates negatively affect productivity, output, and tax revenue. Laffer curve

24. 10/22/201424 Criticisms, rebuttals, and assessment Skeptics say there is ample empirical evidence showing that the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge. Skeptics say there is ample empirical evidence showing that the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge. The issue of where a particular economy is located on its Laffer curve is an empirical question. The issue of where a particular economy is located on its Laffer curve is an empirical question.

25. 10/22/201425 Criticisms, rebuttals, and assessment Supply-side advocates contend that the Reagan tax cuts in the 1980s worked as Laffer predicted. Supply-side advocates contend that the Reagan tax cuts in the 1980s worked as Laffer predicted. The tax-rate cuts did not, however, produce extraordinary rightward shifts of the LRAS.. The tax-rate cuts did not, however, produce extraordinary rightward shifts of the LRAS..

26. 10/22/201426 Criticisms, rebuttals, and assessment There is general agreement that the U.S. economy is operating at a point below m on the Laffer curve. There is general agreement that the U.S. economy is operating at a point below m on the Laffer curve. Supply-side economics has contributed to how economists and policymakers design and implement fiscal policy. Supply-side economics has contributed to how economists and policymakers design and implement fiscal policy.

27. 10/22/201427