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Chapter 35
Extending the
Analysis of
Aggregate
Supply
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill 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 Q2
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 Q f
Real Domestic Output
35-8
Extended AD-AS Model
Recession
Price Level
ASLR
P3
AS2
a
P1
P2
AS1
b
c
AD1
AD2
Q1 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
7
6
5
4
3
2
1
0
0
1
2
3
4
5
6
Unemployment Rate (Percent)
7
Annual Rate of Inflation (Percent)
Annual Rate of Inflation (Percent)
Data for the 1960s
7
69
6
5
68
4
66
67
3
65
2
1
64
63
62
61
0
0
1
2
3
4
5
6
7
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
0
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
9
a3
b2
PC1
6
c3
a1
c2
b1
3
0
a2
3
4
5
6
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
Laffer Curve
m
l
Maximum
Tax Revenue
0
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
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Current Issues
in Macro Theory
and Policy
35-21