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Extending the Analysis of Aggregate Supply
CHAPTER SIXTEEN
EXTENDING THE ANALYSIS OF AGGREGATE SUPPLY
CHAPTER OVERVIEW
This is the first chapter of Part IV, “Long Run Perspectives and Macroeconomic Debates.” This chapter
explains the difference between long-run and short-run aggregate supply; it examines the
unemployment-inflation relationship and assesses the effect of taxes on aggregate supply.
WHAT’S NEW
Most of the organization and content of this chapter remains unchanged.
The definition of the short run has been changed slightly from a period of “fixed nominal wages” to a
period in which “wages do not respond to price level changes,” making it consistent with new language
in Chapter 11.
A “Consider This” box on the “Laffer Curve” has been added. This piece appeared in the previous
edition website in the “Analogies, Anecdotes, and Insights” section.
The “Last Word” on the “Impact of Oil” has been revised and updated. Also, a new Web-Based
Question on “dynamic tax scoring” replaces Web-Based Question 11 (Phillips Curve) from the previous
edition.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. Explain the difference between the short-run and long-run aggregate supply curves and their
significance for economic policy.
2. Distinguish between demand-pull and cost-push inflation using the extended aggregate demandaggregate supply model.
3. Explain and construct a traditional short-run Phillips Curve using the aggregate demand-aggregate
supply model.
4. Differentiate between the short-run and long-run Phillips Curves.
5. Identify the supply-side shocks to the U.S. economy in the 1970s and 1980s.
6. Use an aggregate demand-aggregate supply graph to show how supply-side shocks led to
stagflation in the 1970s and 1980s.
7. Explain why demand-management policies cannot eliminate stagflation.
8. Explain two possible effects of taxation on aggregate supply.
9. Explain the Laffer Curve concept and list three criticisms of this theory.
10. Define and identify the terms at the end of the chapter.
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COMMENTS AND TEACHING SUGGESTIONS
1. The Phillips Curve controversy can be introduced by using actual data such as that shown in
Figure 16-7b. Ask students if they can see any discernible pattern between unemployment and
inflation data without viewing the curves.
2. The aggregate supply and demand model can also be helpful in explaining why demand
management policies might entail supply-side effects that limit the attainment of policy goals. The
shifts in Figures 16-4 and 16-5 illustrate this problem.
3. Demand-pull and cost-push inflation were introduced earlier, so they should be familiar.
However, a review of the aggregate demand and supply model would be a useful way to begin the
discussion. Explain that it is difficult to distinguish the two types of inflation in the real world,
since the causes of inflation are complex. Use Figure 16-3 and 16-4 to illustrate.
4. A speaker who can recall a time or country where wage-price controls were used, and the problems
associated with them, might be interesting for students, who might otherwise believe these controls
are a simple solution.
5. Throughout the discussion of the Phillips Curve, be sure to point out that the vertical axis
measures changes in the price level, not the price level itself (as in the AD-AS model).
STUDENT STUMBLING BLOCKS
1. Students may not see why employment usually declines when policies to reduce inflation are
implemented.
2. Students may have difficulty with the extended AD-AS model. Have them review Figure 16-1
carefully. Current events may give practice in deciding how the event will impact the economy,
through the demand side or the supply side. For example, the potential impact of tax cuts made in
2001 and 2003 could be analyzed.
LECTURE NOTES
I.
Introduction
A. Recent focus on the long-run adjustments and economic outcomes has renewed debates
about stabilization policy and causes of instability.
B. This chapter makes the distinction between short-run and long-run aggregate supply.
C. The extended model is then used to glean new insights on demand-pull and cost-push
inflation.
D. The relationship between inflation and unemployment is examined; we look at how
expectations can affect the economy, and assess the effect of taxes on aggregate supply.
II.
Short-Run and Long-Run Aggregate Supply
A. Definition: Short run and long run.
1. For macroeconomics the short run is a period in which wages (and other input prices) do
not respond to price-level changes.
a. Workers may not be fully aware of the change in their real wages due to inflation (or
deflation) and thus have not adjusted their labor supply decisions and wage demands
accordingly.
b. Employees hired under fixed wage contracts must wait to renegotiate regardless of
changes in the price level.
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Extending the Analysis of Aggregate Supply
2. Long-run aggregate supply (See Figure 16-1b). Formed by long-run equilibrium points
a1, b1, c1.
a. In the long run, nominal wages are fully responsive to price-level changes.
b. The long-run aggregate supply curve is a vertical line at the full employment level of
real GDP. (See Figure 16-1b) (b1, a1, c1).
B. The short-run aggregate supply curve AS1, is constructed with three assumptions. (see Figure
16-1a)
1. The initial price level is given at P1.
2. Nominal wages have been established on the expectation that this specific price level
will persist.
3. The price level is flexible both upward and downward.
4. If the price level rises, higher product prices with constant wages will bring higher
profits and increased output. (See Figure 16-1a.) (The economy moves from a1 to a2
on curve AS1.)
5. If the price level falls, lower product prices with constant wages will bring lower
profits and decreased output. (See Figure 16-1a) (The economy moves from a1 to a3
on curve AS1.)
C. The extended AD-AS makes the distinction between the short-run and long-run aggregate
supply curves. (See Figure 16-2.) Equilibrium occurs at point a where aggregate demand
intersects both the vertical long-run supply curve and the short-run supply curve at full
employment output.
III.
Applying the Extended AD-AS Model
A. Demand-pull inflation: In the short run it drives up the price level and increases real output;
in the long run, only price level rises. (See Figure 16-3.)
B. Cost-push inflation arises from factors that increase the cost of production at each price
level; the increase in the price of a key resource, for example. This shifts the short-run
supply to the left, not as a response to a price-level increase, but as its initiating cause. Costpush inflation creates a dilemma for policymakers. (See Figure 16-4.)
1. If government attempts to maintain full employment when there is cost-push inflation an
inflationary spiral may occur.
2. If government takes a hands-off approach to cost-push inflation, a recession will occur.
The recession may eventually undo the initial rise in per unit production costs, but in the
meantime unemployment and loss of real output will occur.
C. Recession and the extended AD-AS model.
1. When aggregate demand shifts leftward a recession occurs. If prices and wages are
downwardly flexible, the price level falls. The decline in the price level reduces nominal
wages, which then eventually shifts the aggregate supply curve to the right. The price
level declines and output returns to the full employment level. (See Figure 16-5.)
2. This is the most controversial application of the extended AD-AS model. The key point
of dispute is how long it would take in the real world for the necessary price and wage
adjustments to take place to achieve the indicated outcome.
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Extending the Analysis of Aggregate Supply
IV.
The Phillips Curve and the Inflation – Unemployment Tradeoff
A. Both low inflation and low unemployment are major goals. But are they compatible?
B. The Phillips Curve is named after A.W. Phillips, who developed his theory in Great Britain
by observing the British relationship between unemployment and wage inflation.
C. The basic idea is that given the short-run aggregate supply curve, an increase in aggregate
demand will cause the price level to increase and real output to expand, and the reverse for a
decrease in AD. (See Figure 16-6.)
D. This trade-off between output and inflation does not occur over long time periods.
E. Empirical work in the 1960s verified the inverse relationship between the unemployment rate
and the rate of inflation in the United States for 1961-1969. (See Figure 16-7b.)
F. The stable Phillips Curve of the 1960s gave way to great instability of the curve in the 1970s
and 1980s. The obvious inverse relationship of 1961-1969 had become obscure and highly
questionable. (See Figure 16-8.)
1. In the 1970s the economy experienced increasing inflation and rising unemployment:
stagflation.
2. At best, the data in Figure 16-8 suggest a less-desirable combination of unemployment
and inflation. At worse, the data imply no predictable trade-off between unemployment
and inflation.
G. Adverse aggregate supply shocks—the stagflation of the 1970s and early 1980s may have
been caused by a series of adverse aggregate supply shocks. (Rapid and significant increases
in resource costs.)
1. The most significant of these supply shocks was a quadrupling of oil prices by the
Organization of Petroleum Exporting Countries (OPEC).
2. Other factors included agricultural shortfalls, a greatly depreciated dollar, wage increases
and declining productivity.
3. Leftward shifts of the short-run aggregate supply curve make a difference. The Phillips
Curve trade-off is derived from shifting the aggregate demand curve along a stable shortrun aggregate supply curve. (See Figure 16-6.)
4. The “Great Stagflation” of the 1970s made it clear that the Phillips Curve did not
represent a stable inflation/unemployment relationship.
H. Stagflation’s Demise.
1. Another look at Figure 16-8 reveals a generally inward movement of the
inflation/unemployment points between 1982 and 1989.
2. The recession of 1981-1982, largely caused by a tight money policy, reduced doubledigit inflation and raised the unemployment rate to 9.5% in 1982.
3. With so many workers unemployed, wage increases were smaller and in some cases
reduced wages were accepted.
4. Firms restrained their price increases to try to retain their relative shares of diminished
markets.
5. Foreign competition throughout this period held down wages and price hikes.
6. Deregulation of the airline and trucking industries also resulted in wage and price
reductions.
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Extending the Analysis of Aggregate Supply
7. A significant decline in OPEC’s monopoly power produced a stunning fall in the price of
oil.
I.
V.
Global Perspective 16-1 portrays the “misery index” in 1992-2002 for several nations. The
index adds unemployment and inflation rates.
Long-Run Vertical Phillips Curve
A. This view is that the economy is generally stable at its natural rate of unemployment (or fullemployment rate of output).
1. The hypothesis questions the existence of a long-run inverse relationship between the
rate of unemployment and the rate of inflation.
2. Figure 16-9 explains how a short-run trade-off exists, but not a long-run trade-off.
3. In the short run we assume that people form their expectations of future inflation on the
basis of previous and present rates of inflation and only gradually change their
expectations and wage demands.
4. Fully anticipated inflation by labor in the nominal wage demands of workers generates a
vertical Phillips Curve. (See Figure 16-9.) This occurs over time.
B. Interpretations of the Phillips Curve have changed dramatically over the past three decades.
1. The original idea of a stable trade-off between inflation and unemployment has given
way to other views that focus more on long-run effects.
2. Most economists accept the idea of a short-run trade-off—where the short run may last
several years—while recognizing that in the long run such a trade-off is much less likely.
VI.
Taxation and Aggregate Supply
A. Economic disturbances can be generated on the supply side, as well as on the demand side of
the economy. Certain government policies may reduce the growth of aggregate supply.
“Supply-side” economists advocate policies that promote output growth. They argue that
1. The U.S. tax transfer system has negatively affected incentives to work, invest, innovate,
and assume entrepreneurial risks.
a. To induce more work government should reduce marginal tax rates on earned
income.
b. Unemployment compensation and welfare programs have made job loss less of an
economic crisis for some people. Many transfer programs are structured to
discourage work.
2. The rewards for saving and investing have also been reduced by high marginal tax rates.
A critical determinant of investment spending is the expected after-tax return.
3. Lower marginal tax rates may encourage more people to enter the labor force and to
work longer. The lower rates should reduce periods of unemployment and raise capital
investment, which increases worker productivity. Aggregate supply will expand and
keep inflation low.
B. The Laffer Curve is an idea relating tax rates and tax revenues. It is named after economist
Arthur Laffer, who originated the theory. (See Figure 16-10.)
1. As tax rates increase from zero, tax revenues increase from zero to some maximum level
(m) and then decline.
2. Tax rates above or below this maximum rate will cause a decrease in tax revenue.
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3. Laffer argued that tax rates were above the optimal level and that by lowering tax rates
government could increase the tax revenue collected.
4. The lower tax rates would trigger an expansion of real output and income enlarging the
tax base. The main impact would be on supply rather than aggregate demand.
5. CONSIDER THIS … Sherwood Forest
Laffer likened the paying of taxes to passing through Sherwood Forest. To avoid Robin
Hood’s “taxation,” people avoided going through the forest whenever possible. If Robin
Hood had confiscated only a portion, his band’s revenue might have been higher as less
people would have avoided or evaded the forest (taxes).
C. Supply side economists offer two additional reasons for lowering the tax rate.
1. Tax avoidance (legal) and tax evasion (illegal) both decline when taxes are reduced.
2. Reduced transfers—tax cuts stimulate production and employment, reducing the need for
transfer payments such as welfare and unemployment compensation.
D. Criticisms of the Laffer Curve.
1. There is empirical evidence that the impact on incentives to work, save, and invest are
small.
2. Tax cuts also increase demand, which can fuel inflation. Demand impacts may exceed
supply impacts.
3. The Laffer Curve (Figure 16-10) is based on a logical premise, but where the economy is
actually located on the curve is an empirical question and difficult to determine. It may
be hard to know in advance the impact of a tax cut on supply.
VII.
LAST WORD: Has the Impact of Oil Prices Diminished?
A. Oil price changes have caused numerous (supply-side) shocks to the U.S. economy. The
worst (in terms of impact) occurred in the mid-1970s, and “reverse” shocks in the late 1980s
and 1990s actually benefited the U.S. macroeconomy.
B. Output restrictions beginning in 1999 raised oil prices significantly (up to $34 a barrel),
igniting fear that cost-push inflation and inflation would occur. It didn’t for several reasons.
1. The adverse shock was offset by positive supply shocks such as increased productivity.
2. Oil prices and consumption have declined in relative importance to the overall price level
and production of the United States.
3. Federal Reserve policy has pursued and maintained price stability with greater effort and
success than in the 1970s.
ANSWERS TO END-OF-CHAPTER QUESTIONS
16-1
Distinguish between the short run and the long run as they relate to macroeconomics.
For macroeconomists the short run is a period in which wages (and other input prices) do not
respond to price level changes. There are at least two reasons why nominal wages may remain
constant for a while even though the price level has changed.
1. Workers may not be aware of price level changes, and thus have not adjusted their demands.
2. Many employees are hired under fixed wage contracts.
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Once sufficient time has elapsed for contracts to expire and nominal wage adjustments to occur,
the economy enters the long run, a period in which nominal wages are fully responsive to
changes in the price level.
16-2
Which of the following statements are true? Which are false? Explain why the false statements
are untrue.
a. Short-run aggregate supply curves reflect an inverse relationship between the price level and
the level of real output.
b. The long-run aggregate supply curve assumes that nominal wages are fixed.
c. In the long run, an increase in the price level will result in an increase in nominal wages.
(a) False, short-run aggregate supply curves reflect a direct relationship between the price level
and the level of real output. If there is an increase in the price level, the higher product
prices bring an increase in revenue from sales to business firms. Since the nominal wages
they are paying are fixed, their profits rise. In response, firms collectively increase their
output. Producers respond to a decrease in the price level by cutting output. When product
prices fall with nominal wages constant, firms will discover their revenue and profits have
diminished.
(b) False, by definition, nominal wages in the long run are fully responsive to changes in the
price level.
(c) True, as above.
16-3
(Key Question) Suppose the full-employment level of real output (Q) for a hypothetical economy
is $250 and the price level (P) initially is 100. Use the short-run aggregate supply schedules
below to answer the questions that follow.
AS(P=100)
P
Q
125
100
75
280
250
220
AS(P=125)
P
Q
125
100
75
250
220
190
AS(P=75)
P
Q
125
100
75
310
280
250
a. What will be the level of real output in the short run if the price level unexpectedly rises
from 100 to 125 because of an increase in aggregate demand? What if the price level falls
unexpectedly from 100 to 75 because of a decrease in aggregate demand? Explain each
situation, using numbers from the table.
b. What will be the level of real output in the long run when the price level rises from 100 to
125? When it falls from 100 to 75? Explain each situation.
c. Show the circumstances described in parts a and b on graph paper, and derive the long-run
aggregate supply curve.
(a) $280; $220. When the price level rises from 100 to 125 [in aggregate supply schedule
AS(P100)], producers experience higher prices for their products. Because nominal wages
are constant, profits rise and producers increase output to Q = $280. When the price level
decreases from 100 to 75, profits decline and producers adjust their output to Q = $75.
These are short-run responses to changes in the price level.
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Extending the Analysis of Aggregate Supply
(b) $250; $250. In the long run a rise in the price level to 125 leads to nominal wage increases.
The AS(P100) schedule changes to AS(P125) and Q returns to $250, now at a price level of
125. In the long run a decrease in price level to 75 leads to lower nominal wages, yielding
aggregate supply schedule AS(P75). Equilibrium Q returns to $250, now at a price level of
75.
(c) Graphically, the explanation is identical to Figure 16-1b. Short-run AS: P1 = 100; P2 =
125; P3 = 75; and Q1 = $250; Q2 = $280; and Q3 = $220. Long-run aggregate supply = Q1
= $250 at each of the three price levels.
16-4
(Key Question) Use graphical analysis to show how each of the following would affect the
economy first in the short run and then in the long run. Assume that the United States is initially
operating at its full-employment level of output, that prices and wages are eventually flexible
both upward and downward, and that there is no counteracting fiscal or monetary policy.
a. Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices
rocketing upward.
b. Construction spending on new homes rises dramatically, greatly increasing total U.S.
investment spending.
c. Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports.
(a) See Figure 16-4 in the chapter, less AD2. Short run: The aggregate supply curve shifts to the
left, the price level rises, and real output declines. Long run: The aggregate supply curve
shifts back rightward (due to declining nominal wages), the price level falls, and real output
increases.
(b) See Figure 16-3. Short run: The aggregate demand curve shifts to the right, and both the
price level and real output increase. Long run: The aggregate supply curve shifts to the left
(due to higher nominal wages), the price level rises, and real output declines.
(c) See Figure 16-5. Short run: The aggregate demand curve shifts to the left, both the price
level and real output decline. Long run: The aggregate supply curve shifts to the right, the
price level falls further, and real output increases.
16-5
Assume there is a particular short-run aggregate supply curve for an economy and that the curve
is relevant for several years. Use the AD-AS analysis to show graphically why higher rates of
inflation over this period would be associated with lower rates of unemployment, and vice versa.
What is the inverse relationship called?
As aggregate demand increases given a particular short-run aggregate supply curve, increases in
real output are associated with increases in the price level. When real output increases, the
unemployment rate decreases. The Phillips Curve shown on the right expresses the same
relationship as the AD-AS model, but graphs as an inverse relationship because unemployment is
on the horizontal axis rather than real output.
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Extending the Analysis of Aggregate Supply
16-6
(Key Question) Suppose the government misjudges the natural rate of unemployment to be much
lower than it actually is, and thus undertakes expansionary fiscal and monetary policy to try to
achieve the lower rate. Use the concept of the short-run Phillips Curve to explain why these
policies might at first succeed. Use the concept of the long-run Phillips Curve to explain the
long-run outcome of these policies.
In the short run there is probably a trade-off between unemployment and inflation. The
government’s expansionary policy should reduce unemployment as aggregate demand increases.
However, the government has misjudged the natural rate and will continue its expansionary
policy beyond the point of the natural level of unemployment. As aggregate demand continues to
rise, prices begin to rise. In the long run, workers demand higher wages to compensate for these
higher prices. Aggregate supply will decrease (shift leftward) toward the natural rate of
unemployment.
In other words, any reduction of unemployment below the natural rate is only temporary and
involves a short-run rise in inflation. This, in turn, causes long-run costs to rise and a decrease in
aggregate supply. The end result should be an equilibrium at the natural rate of unemployment
and a higher price level than the beginning level. The long-run Phillips curve is thus a vertical
line connecting the price levels possible at the natural rate of unemployment found on the
horizontal axis. (See Figure 16-9.)
16-7
What do the distinction between short-run and long-run aggregate supply have in common with
the distinction between the short-run and long-run Phillips Curves? Explain.
In the short run, economists assume that production costs don’t change so the aggregate supply
curve is fixed. Therefore, changes in aggregate demand are the sole determinant of
unemployment and inflation rates. (Figure 16-1a) In the long run, wages and input prices adjust
to price changes causing a rise (or fall) in production costs and aggregate supply decreases (or
increases) as shown in Figure 16-1b. This means the long-run relationship between price level
and output is vertical at the full-employment level of output.
The long-run Phillips curve illustrates this latter point with the natural rate of unemployment
(sometimes called the full-employment rate) being measured on the horizontal axis and price
level on the vertical axis. The long-run curve is vertical as shown in Figure 16-9. However, the
short-run Phillips curve reflects what happens with unemployment at different price levels using
the short-run aggregate supply curve. (See Figures 16-6 and 16-7.)
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16-8
(Key Question) What is the Laffer Curve and how does it relate to supply-side economics? Why
is determining the location where the economy is on the curve so important in assessing tax
policy?
Economist Arthur Laffer observed that tax revenues would obviously be zero when the tax rate
was either at 0% or 100%. In between these two extremes would have to be an optimal rate
where aggregate output and income produced the maximum tax revenues. This idea is presented
as the Laffer Curve shown in Figure 16-10.
The difficult decision involves the analysis to determine the optimum tax rate for producing
maximum tax revenue and the related maximum economic output level. Laffer argued that low
tax rates would actually increase revenues because low rates improved productivity, saving, and
investment incentives. The expansion in output and employment and thus, revenue, would more
than compensate for the lower rates.
16-9
Why might one person work more, earn more, and pay more income tax when his or her tax rate
is cut, while another person will work less, earn less, and pay less income tax under the same
circumstance?
Proponents of supply-side economics argue that cuts in the marginal tax rate on earned income
will make work more attractive because the opportunity cost of leisure is higher. Thus,
individuals choose to substitute work for leisure. Critics of supply-side reasoning contend that
workers are just as likely to reduce their efforts because the after-tax pay increases their ability to
“buy leisure.” They can meet their after-tax income goals by working fewer hours.
16-10 (Last Word) Do oil prices play a smaller role or a larger role in the U.S. economy today
compared to the 1970s and 1980s? Explain why or why not.
Changes in oil prices have a smaller impact today than in the 1970s and 1980s for several
reasons. First, the beneficial effects on cost reduction of technology improvements offset higher
energy costs. Second, the Federal Reserve has become better at maintaining overall price
stability through monetary policy. Third, energy costs are not as large a proportion of production
costs as they used to be. Experts estimate that the U.S. economy is one-third less sensitive to oil
price changes than in early 1980s.
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