Chapter 35 - Extending the analysis of aggregate supply. In this chapter, students will be able to understand: Explain the relationship between short-run aggregate supply and long-run aggregate supply; discuss how to apply the extended (short-run/long-run) AD-AS model to inflation, recessions, and economic growth; explain the short-run trade-off between inflation and unemployment (the Phillips Curve);...
Chapter 35 Extending the Analysis of Aggregate Supply McGrawHill/Irwin Copyright © 2009 by The McGrawHill Companies, Inc. All rights reserved Chapter Objectives • Relationship between short-run and long-run aggregate supply • Applying the “extended” AD-AS model • The Phillips curve • No long-run tradeoff between inflation and unemployment • Taxes and aggregate supply 35-2 From Short Run to Long Run • Short run – Input prices inflexible – Upward sloping aggregate supply • Long run – Input prices fully flexible – Vertical aggregate supply • The transition? 35-3 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… 35-4 From Short Run to Long Run Short-Run Aggregate Supply Long-Run Aggregate Supply a2 P2 a1 P1 P3 a3 Q3 ASLR AS2 Price Level Price Level AS1 P2 Qf Q2 Real Domestic Output a1 P1 P3 a2 b1 AS1 AS3 a3 c1 Qf Real Domestic Output 35-5 Extended AD-AS Model Long Run Equilibrium Price Level ASLR AS1 a P1 AD1 Qf Real Domestic Output 35-6 Extended AD-AS Model Demand-Pull Inflation Price Level ASLR P3 AS1 b c P2 P1 AS2 a AD2 AD1 Qf Q Real Domestic Output 35-7 Extended AD-AS Model Cost-push inflation If government counters recession with spending… If government ignores recession… Price Level ASLR AS1 c P3 P2 AS2 b a P1 AD2 AD1 Q2 Qf Real Domestic Output 35-8 Extended AD-AS Model Recession Price Level ASLR P3 AS2 a P1 P2 AS1 b c AD1 AD2 Q Qf Real Domestic Output 35-9 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 35-10 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 35-11 The Phillips Curve • Demonstrates short-run tradeoff between inflation and unemployment Concept Empirical Data 0 Unemployment Rate (Percent) Annual Rate of Inflation (Percent) Annual Rate of Inflation (Percent) Data for the 1960s 69 68 66 67 65 64 63 62 61 0 Unemployment Rate (Percent) 35-12 The Phillips Curve Underlying rationale of the Phillips Curve Price Level AS P3 P2 AD3 P1 P0 AD2 AD1 AD0 Q0 Q1 Q2 Q3 Real Domestic Output 35-13 The Phillips Curve • 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 35-14 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 35-15 The Long-Run Phillips Curve PCLR Annual Rate of Inflation (Percent) 15 PC3 12 b3 PC2 a3 b2 PC1 c3 a1 c2 b1 a2 Unemployment Rate (Percent) 35-16 Taxes and Aggregate Supply Supply-side economics Tax incentives to work Tax incentives to save and invest The Laffer curve 100 Tax Rate (Percent) • • • • n m m l Laffer Curve Maximum Tax Revenue Tax Revenue (Dollars) 35-17 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 35-18 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 effects of tax changes from other effects • Investment falls sharply in response to tax changes 35-19 Key Terms • • • • • • • • • short run long run Phillips Curve stagflation aggregate supply shocks long-run vertical Phillips Curve disinflation supply-side economics Laffer Curve 35-20 Next Chapter Preview… Current Issues in Macro Theory and Policy 35-21 ... a3 c1 Qf Real Domestic Output 3 5- 5 Extended AD-AS Model Long Run Equilibrium Price Level ASLR AS1 a P1 AD1 Qf Real Domestic Output 3 5- 6 Extended AD-AS Model Demand-Pull Inflation Price Level ASLR... changes 3 5- 19 Key Terms • • • • • • • • • short run long run Phillips Curve stagflation aggregate supply shocks long-run vertical Phillips Curve disinflation supply-side economics Laffer Curve 3 5- 20... 1980s 3 5- 14 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 3 5- 15