35 Extending the Analysis of Aggregate Supply Mc

35 Extending the Analysis of Aggregate Supply Mc. Graw-Hill/Irwin Copyright © 2012 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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? LO 1 35 -2

From Short Run to Long Run • Production above potential output: • High demand for inputs • Input prices rise • Short run aggregate supply shifts • • LO 1 left • Return to potential output Production below potential output Graphical examples… 35 -3

From Short Run to Long Run Short-Run Aggregate Supply Long-Run Aggregate Supply a 2 P 2 a 1 P 3 a 3 Qf Q 2 AS 2 a 2 b 1 P 2 AS 1 AS 3 a 1 P 3 Real Domestic Output LO 1 ASLR Price Level AS 1 a 3 c 1 Qf Real Domestic Output 35 -4

From Short Run to Long Run Equilibrium Price Level ASLR AS 1 a P 1 AD 1 Qf Real Domestic Output LO 1 35 -5

Extended AD-AS Model Demand-Pull Inflation Price Level ASLR P 3 AS 1 c b P 2 P 1 AS 2 a AD 2 AD 1 Qf Q 2 Real Domestic Output LO 2 35 -6

Extended AD-AS Model Cost-Push Inflation Price Level ASLR AS 1 c P 3 P 2 AS 2 b a P 1 AD 2 AD 1 Q 2 Qf Real Domestic Output LO 2 35 -7

Extended AD-AS Model Recession Price Level ASLR P 3 AS 2 a P 1 P 2 AS 1 b c AD 1 AD 2 Q 1 Qf Real Domestic Output LO 2 35 -8

Extended AD-AS Model • Explaining ongoing inflation • Ongoing economic growth shifts • LO 2 aggregate supply • Ongoing increases in money supply shift aggregate demand Small positive rate of inflation 35 -9

Economic Growth, Ongoing Inflation Consumer Goods Increase in production possibilities LO 2 Long Run Aggregate Supply Price Level Capital Goods Productions Possibilities Real GDP Increase in long-run aggregate supply 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 • LO 3 rise No long-run tradeoff 35 -11

The Phillips Curve • 1960 s economists believed in stable, • • • LO 3 predictable tradeoff Phillips curve shifts over time Adverse supply shocks 1970 s • OPEC oil price shock • Stagflation’s demise 1980 s 35 -12

Alban William Phillips

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 (increase the purchasing power of the local currency that is shown in the reduction of the price index) LO 4 35 -14

The Phillips Curve Annual rate of inflation (percent) 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unemployment rate (percent) LO 4 35 -15

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 LO 5 m l 0 Laffer Curve Maximum Tax Revenue (Dollars) 35 -16

Taxes and Aggregate Supply • Criticisms of the Laffer curve • Taxes, incentives, and time • Inflation and higher real interest • LO 5 rates • Position on the curve Rebuttal and evaluation 35 -17