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Jacob Schulman
AP Economics
June 26, 2017
Mr. Coggin
Chapter 16: Extending the Analysis of Aggregate Supply
Introduction:
A. Long-run economic outcomes have renewed debates about stabilization policy and causes
of instability
B. The chapter distinguishes between short run and long run aggregate supply
- Extended model is used to glean new insights on demand-pull and cost-push inflation
C. Investigate the relationship between inflation and unemployment
- How expectations can affect the economy, and how taxes impact aggregate supply
I. Short-Run and Long-Run Aggregate Supply:
A. Short Run: Period in which nominal wages (and other input prices) remain fixed as the price
level changes
- Workers might not be totally aware of the change in their real wages due to inflation or
deflationThey don’t necessarily adjust their decisions and demands properly
B. Employees hired under fixed wage contracts have to wait to renegotiate regardless of price
level changes
C. In the long run, nominal wages are fully responsive to price level changesLong run
aggregate supply curve is a vertical line at the full employment level of real GDP
D. Short-run Aggregate Supply: Made with three assumptions
1. Initial price level is given
2. Nominal wages have been established on the expectation that this specific price level will
be the same throughout
3. Price level is flexible both upward and downward
E. If price level rises, higher product prices with constant wages will bring higher profits and
increased output
F. If price level ralls, lower product price with constant wages will bring lower profits and
decreased output
G. Extended aggregate demand / aggregate supply makes distinction between short and long
run aggregate supply curves
- Equilibrium occurs at point where aggregate demand intersects vertical long run supply
curve and the short run supply at full employment output
II. Applying the Extended AD-AS Model:
A. Demand-Pull Inflation: Drives up price level in the short run and increases real output
- In the long run, only the price level rises
B. Cost push inflation: Arises from factors that increase the cost of production at each price
levelsomething like an increased price for a resource
- Shifts the short run supply to the leftreflects the initiating cost
- Cost-push inflation makes problems for lawmakers
C. If government tries to maintain full employment when there’s cost-push inflation, there could
be a lot more inflation very quickly afterwards
D. If gvt tries to let the inflation take its course, a recession will probably occur
Probably can undo the initial rise in per unit production costs, but there will be more
unemployment and a loss of real output until that happens
Recession and the Extended AD-AS Model:
A. When AD shifts to the left, there is a recession
- If the prices and wages are flexible, then the price level fallsReduces nominal wages
which will then shift the aggregate supply curve to the right
Price level declines and output returns to full employment
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B. It’s controversial to predict the extended AD-AS modelNot really 100% sure on how long it
would take in the real world for all the price and wage adjustments to take place and achieve
the indicated outcome
III. The Inflation-Unemployment Relationship:
A. Low inflation and low unemployment are both major goals, but aren’t necessarily compatible
B. Philips Curve: Named after A.W. PhilipsObserved the British relationship between
unemployment and wage inflation
C. Given the short run aggregate supply curve, an increase in aggregate demand will cause the
price level to increase and real output to expand
- The opposite happens for a decrease in AD
D. Tradeoff between output and inflation doesn’t occur over long periods, instead it happens
over short quick periods of time
E. Work in the 1960s verified the inverse relationshipProven to be true for unemployment
rate and inflation rate in the US between 1961 and 1969
F. Stable Philips curve of the 1960s changed over to the instability curve in the 1970s and 80s
- The obvious inverse relationship that was proven in the 60s was then questioned
- In the 70s, there was increasing inflation and rising unemploymentStagflation
- If you believe in the curve, it showed a less desireable of unemployment and inflation
- Data can also imply that there is no predictability between unemployment and inflation
Adverse Aggregate Supply Shocks:
A. Stagflation of the 1970s and 1980s may have been caused by a series of adverse aggregate
supply shocks
- These rapid and significant increases in resource costs had big impacts
B. Most significant of these was the oil embargo that OPEC did against the US
- Led to 4x oil prices because of Organization of Petroleum Exporting Countries (OPEC)
C. Agricultural shortfalls, a depreciated dollar, wage increases, and declining productivity were
both factors that led to the declining productivity
D. Short run aggregate supply curve shifted to the left and made a differencePhilips curve
trade off is derived from shifting aggregate demand along a stable short-run AS curve
E. “Great Stagflation” of the 70s showed that the Philips Curve didn’t represent a stable inflation
/unemployment relationship
Stagflation’s Demise:
A. There was generally inward movement of inflation / unemployment between 1982 and 1989
B. Recession of 1981-1982 was caused by tight money policyreduced the inflation and raised
the unemployment rate to 9.5% in 1982
- Wage increases were smaller and people even took reduced wages in some cases
C. Firms had to restrain price increases to retain their shares of diminished markets
D. Foreign competition throughout this period held down wages and price hikes
E. Deregulation of airline and trucking industries resulted in wage and price reductions
IV. The Long-Run Phillips Curve:
A. Long-Run Phillips Curve View: economy is generally stable at its natural rate of
unemployment (or full-employment rate of output)
- Questions existence of a long-run inverse relationship between the rate of unemployment
and the rate of inflation
B. 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
C. Fully anticipated inflation generates a vertical Phillips curve
D. Interpretations have changed a lot over the past years:
- Focuses more on long-run effects instead of short run effects
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E. Most economists accept the idea of a short run tradeoff where it can last several years, and
recognize that a long term one is much less likely
V. Taxation and Aggregate Supply:
A. Economic disturbances can be generated on the supply side and the demand side of the
economy
- Government policies can reduce growth of aggregate supply
B. “Supply side economists” advocate policies that promote output growth
C. US tax transfer system has negatively affected incentives to work, invest, innovate, and
assume entrepreneurial risks
- Government should reduce income taxes to induce more work by people
D. Job loss is less of an economic crisis for people because of unemployment compensation
and welfare programs
It’s as if some of these programs are structured to discourage work
E. Rewards for saving and investing have been reduced by high tax rates
Expected rate of return is a huge factor in determining investment spending
F. Lower marginal tax rates encourage people enter the labor force and work more
would reduce periods of unemployment and raise investment
Will help increase aggregate supply and keep inflation low
G. Impact on incentives to work, save, and invest are relatively small
H. Tax cuts also increase demandFuels inflation
- Demand impact exceeds supply impact
I. Laffer Curve: Where the economy is located is an empirical question and difficult to
determine
Hard to know in advance the impact of a tax cut on supply
Pages 323-327:
I. Ingredients of Growth:
Supply Factors: Changes in the physical and technical agents of production
A. Physical ability of the economy to expand:
1. Increases in quantity and quality of natural resources
2. Increases in quantity and quality of human resources
3. Increases in supply of capital goods
4. Improvements in technology
Demand Factor:
A. To achieve higher production potential created by supply factors, households, businesses,
and gvts must purchase the economy’s expanding output of goods and services
Efficiency Factor:
A. To reach full production potential, an economy must achieve economic efficiency and full
employment
B. Has to use resources in least costly way to produce the mix of goods and services that
maximizes people’s well-being
C. Supply, demand, and efficincy factors are relatedUnemployment caused by insufficient
total spending may lower the rate of new capital accumulation and delay expenditures on
research
II. Production Possibilities Analysis:
A. Growth can be illustrated with a production possibilities curveGrowth is indicated as an
outward shift of the curve
B. Aggregate demand must increase to sustain full employment at each new level of production
possible in the economy
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C. Additional resources that shift the curve outward must be efficiently employed to make
maximum possible contribution to domestic output
D. For economy to achieve maximum increase in monetary value, optimal combination of
goods must be achivedAllocative efficiency
Labor and Productivity:
A. Labor Productivity: (measured as real output per worker per hour)
- Real GDP = worker-hours x labor productivity
B. Increased labor inputs depend on size of population and labor force participation rate (the
percent of population that is part of the labor force)
C. Productivity is determined by technological progress, availability of capical goods, quality of
labor itself, efficiency
D. Labor Force Participation Rate: Percentage of the working age population actually in the
labor force
Growth in the AD-AS Model:
A. AD-AS framework can be used to show growth
- Aggregate supply shifts outward with economic growth
- Nominal GDP rises faster than real GDP
B. Extended AD-AS Model: If prices and wages are inflexible downward, the economy can
realize its greater production potential only through an increase in aggregate demand
- Usually, this kind of increase is forthcoming because the production of additional output
produces additional income to households and businesses
- Increases in aggregate supply and aggregate demand have increased real output and
boosted price level in the chart on the textbook
C. Economic growth results from increases in aggregate supply and aggregate demand
- Whether zero, mild, or rapid inflation accompanies economic growth depends on the extent
to which aggregate demand increases relative to aggregate supply
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