Chapter 18

Extending the Analysis of Aggregate Supply

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18-2

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

18-3

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…

LO1

18-4

From Short Run to Long Run

P3

P1

P2

P3

P1

P2

Real Domestic Output Real Domestic Output

Qf

Short-RunAggregate Supply

Long-RunAggregate Supply

a1

a2

a3

b1

c1

Pric

e Le

vel

Pric

e Le

vel

AS3

AS2AS1ASLR

Qf Q2Q3

AS1

a1

a2

a3

LO1

18-5

From Short Run to Long Run

Real Domestic Output

Long Run EquilibriumPr

ice

Leve

l

P1

Qf

a

AS1ASLR

AD1

LO1

18-6

Extended AD-AS Model

Real Domestic Output

Demand-Pull Inflation Pr

ice

Leve

l

P1

Qf

a

AS1ASLR

AD1

AD2

AS2

c

bP2

P3

Q2

LO2

18-7

Extended AD-AS Model

Real Domestic Output

Cost-Push Inflation Pr

ice

Leve

l

P1

Qf

a

AS1ASLR

AD1

AD2

AS2

b

c

P2

P3

Q2

LO2

18-8

Extended AD-AS Model

Real Domestic Output

RecessionPr

ice

Leve

l P1

Qf

a

AS1ASLR

AD1AD2

AS2

b

c

P2P3

Q1

LO2

18-9

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

LO2

18-10

Pric

e Le

vel

Real GDP

Capi

tal G

oods

Consumer Goods

Productions Possibilities

Long Run Aggregate Supply

Increase in production possibilities

Increase in long-run aggregate supply

LO2

Economic Growth, Ongoing Inflation

18-11

P1

P2

Q2Q10

Pric

e le

vel

Real GDP

ASLR1 ASLR2

AS1

AS2

AD1

AD2

U.S. Growth

LO2

18-12

Inflation and Unemployment

• Low inflation and low unemployment rates• Fed’s major goals• Compatible or conflicting?

• Short-run tradeoff• Aggregate supply shocks cause both rates to

rise• No long-run tradeoff

LO3

18-13

The Phillips Curve

Real Domestic Output

Pric

e Le

vel

0

P0

P1

P2

P3

Q0 Q1 Q2 Q3

AD0

AD1

AD2

AD3

AS

LO3

18-14

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7

Unemployment Rate (Percent)

An

nu

al

Ra

te o

f In

fla

tio

n (

Pe

rce

nt)

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7An

nu

al

Ra

te o

f In

fla

tio

n (

Pe

rce

nt)

Unemployment Rate (Percent)

• Demonstrates short-run tradeoff between inflation and unemployment

69

68

6766

65

64

6362

61

Concept Empirical DataData for the 1960s

The Phillips Curve

LO3

18-15

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

LO3

18-16

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

LO4

18-17

The Phillips Curve

LO4

14

13

12

11

10

9

8

7

6

5

4

3

2

1

An

nu

al r

ate

of

infl

atio

n (

per

cen

t)

Unemployment rate (percent)

18-18

The Phillips Curve

The Misery Index, Selected Nations, 2001-2012

LO4

18-19

The Long-Run Phillips Curve

3 4 5 60

3

6

9

12

15An

nual

Rat

e of

Infla

tion

(Per

cent

)

Unemployment Rate (Percent)

PCLR

PC3

PC2

PC1

a1

b1

a2

a3

b2

b3

c3

c2

LO4

18-20

Taxes and Aggregate Supply

• Supply-side economics• Tax and incentives to work• Incentives to save and invest• The Laffer curve

Tax

Rate

(Per

cent

)

Tax Revenue (Dollars)

100

m

0

n

l

m

Laffer Curve

MaximumTax Revenue

LO5

18-21

Taxes and Aggregate Supply

• Criticisms of the Laffer curve• Taxes, incentives, and time• Inflation or higher real interest rates• Position on the curve

• Rebuttal and evaluation

LO5

18-22

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 the effects of tax changes

from other effects• Investment falls sharply in response to tax

changes

LO5