After reading this chapter, you should be able to: 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);...
18 ExtendingtheAnalysisofAggregateSupply McGrawưHill/Irwin Copyrightâ2012byTheMcGrawưHillCompanies,Inc.Allrightsreserved FromShortRuntoLongRun Short run Input prices inflexible • Upsloping aggregate supply • Long run • Input prices fully flexible • Vertical aggregate supply • The transition? LO1 18-2 From Short Run to Long Run • Production above potential output: • High demand for inputs • Input prices rise • Short run aggregate supply shifts • • LO1 left • Return to potential output Production below potential output Graphical examples… 18-3 From Short Run to Long Run Short-Run Aggregate Supply Long-Run Aggregate Supply a2 P2 a1 P1 P3 a3 Q3 Qf Q2 AS2 a2 b1 P2 AS1 AS3 a1 P1 P3 Real Domestic Output LO1 ASLR Price Level Price Level AS1 a3 c1 Qf Real Domestic Output 18-4 From Short Run to Long Run Long Run Equilibrium Price Level ASLR AS1 a P1 AD1 Qf Real Domestic Output LO1 18-5 Extended ADAS Model Demand-Pull Inflation Price Level ASLR P3 AS1 c b P2 P1 AS2 a AD2 AD1 Qf Q Real Domestic Output LO2 18-6 Extended ADAS Model Cost-Push Inflation Price Level ASLR AS1 c P3 P2 AS2 b a P1 AD2 AD1 Q2 Qf Real Domestic Output LO2 18-7 Extended ADAS Model Recession Price Level ASLR P3 AS2 a P1 P2 AS1 b c AD1 AD2 Q1 Qf Real Domestic Output LO2 18-8 Extended ADAS Model • Explaining ongoing inflation • Ongoing economic growth shifts • LO2 aggregate supply • Ongoing increases in money supply shift aggregate demand Small positive rate of inflation 18-9 Economic Growth, Ongoing Inflation Consumer Goods Increase in production possibilities LO2 Long Run Aggregate Supply Price Level Capital Goods Productions Possibilities Real GDP Increase in long-run aggregate supply 18-10 Inflation and Unemployment • Low inflation and unemployment • Fed’s major goals • Compatible or conflicting? • Short-run tradeoff • Supply shocks cause both rates to • LO3 rise No long-run tradeoff 18-11 The Phillips Curve • 1960s economists believed in stable, • • • LO3 predictable tradeoff Phillips curve shifts over time Adverse supply shocks 1970s • OPEC oil price shock • Stagflation Stagflation’s demise 1980s 18-12 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 18-13 The Phillips Curve Annual rate of inflation (percent) 14 13 12 11 10 Unemployment rate (percent) LO4 18-14 Taxes and Aggregate Supply • Supply-side economics • Tax incentives to work • Tax incentives to save and invest • The Laffer curve Tax Rate (Percent) 100 n m LO5 m l Laffer Curve Maximum Tax Revenue Tax Revenue (Dollars) 18-15 Taxes and Aggregate Supply • Criticisms of the Laffer curve • Taxes, incentives, and time • Inflation and higher real interest • LO5 rates • Position on the curve Rebuttal and evaluation 18-16 ... run aggregate supply shifts • • LO1 left • Return to potential output Production below potential output Graphical examples… 1 8-3 From Short Run to Long Run Short-Run Aggregate Supply Long-Run Aggregate. .. conflicting? • Short-run tradeoff • Supply shocks cause both rates to • LO3 rise No long-run tradeoff 1 8-1 1 The Phillips Curve • 1960s economists believed in stable, • • • LO3 predictable tradeoff Phillips... inflation • Ongoing economic growth shifts • LO2 aggregate supply • Ongoing increases in money supply shift aggregate demand Small positive rate of inflation 1 8-9 Economic Growth, Ongoing Inflation Consumer