1. 18 Extending the Analysis of Aggregate Supply McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. From Short Run to Long Run Short run Input prices inflexible Upsloping aggregate supply Long run Input prices fully flexible Vertical aggregate supply The transition? LO1 18-2

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… LO1 18-3

4. From Short Run to Long Run P3P3 P1P1 P2P2 P3P3 P1P1 P2P2 Real Domestic Output QfQf Short-Run Aggregate Supply Long-Run Aggregate Supply a1a1 a2a2 a3a3 b1b1 c1c1 Price Level AS 3 AS 2 AS 1 AS LR QfQf Q2Q2 Q3Q3 AS 1 a1a1 a2a2 a3a3 LO1 18-4

5. From Short Run to Long Run Real Domestic Output Long Run Equilibrium Price Level P1P1 QfQf a AS 1 AS LR AD 1 LO1 18-5

6. 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 c b P2P2 P3P3 Q2Q2 LO2 18-6

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 Q2Q2 LO2 18-7

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 LO2 18-8

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 LO2 18-9

10. Price Level Real GDP Capital Goods Consumer Goods Economic Growth, Ongoing Inflation Productions Possibilities Long Run Aggregate Supply Increase in production possibilities Increase in long-run aggregate supply LO2 18-10

11. P1P1 P2P2 Q2Q2 Q1Q1 0 Price level Real GDP AS LR1 AS LR2 AS 1 AS 2 AD 1 AD 2 U.S. Growth LO2 18-11

12. 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 LO3 18-12

13. 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 LO3 18-13

14. Unemployment Rate (Percent) Annual Rate of Inflation (Percent) Unemployment Rate (Percent) Demonstrates short-run tradeoff between inflation and unemployment 69 68 67 66 65 64 63 62 61 ConceptEmpirical Data Data for the 1960s The Phillips Curve LO3 18-14

15. 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 LO3 18-15

16. 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 LO4 18-16

17. The Phillips Curve LO4 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Annual rate of inflation (percent) Unemployment rate (percent) 18-17

18. The Phillips Curve The Misery Index, Selected Nations, 1999-2009 15 10 5 1999 2001 200320052007 2009 Source: Bureau of Labor Statistics,stats.bls.gov LO4 18-18

19. The Long-Run Phillips Curve 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 LO4 18-19

20. 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 LO5 18-20

21. 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 LO5 18-21

22. 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 the effects of tax changes from other effects Investment falls sharply in response to tax changes LO5 18-22