Extending the Analysis of Aggregate Supply McGraw-Hill/Irwin Copyright

Extending the Analysis of Aggregate Supply McGraw-Hill/Irwin Copyright © 2012 by The McGraw-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? LO1 35-2

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 35-3

From Short Run to Long Run P3 P1 P2 P3 P1 P2 Real Domestic Output Real Domestic Output Qf Short-Run Aggregate Supply Long-Run Aggregate Supply a1 a2 a3 b1 c1 Price Level Price Level AS3 AS2 AS1 ASLR Qf Q2 Q3 AS1 a1 a2 a3 LO1 35-4

From Short Run to Long Run Real Domestic Output Long Run Equilibrium Price Level P1 Qf a AS1 ASLR AD1 LO1 35-5

Extended AD-AS Model Real Domestic Output Demand-Pull Inflation Price Level P1 Qf a AS1 ASLR AD1 AD2 AS2 c b P2 P3 Q2 LO2 35-6

Extended AD-AS Model Real Domestic Output Cost-Push Inflation Price Level P1 Qf a AS1 ASLR AD1 AD2 AS2 b c P2 P3 Q2 LO2 35-7

Extended AD-AS Model Real Domestic Output Recession Price Level P1 Qf a AS1 ASLR AD1 AD2 AS2 b c P2 P3 Q1 LO2 35-8

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 35-9

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 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 LO3 35-11

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 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) LO4 35-14

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) 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) Tax Revenue (Dollars) 100 m 0 n l m Laffer Curve Maximum Tax Revenue LO5 35-16

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 35-17