Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The...

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Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Page 1: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Extending the Analysis of Aggregate Supply

Chapter 18

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Page 2: Extending the Analysis of Aggregate Supply Chapter 18 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

18-2

Page 3: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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?18-3

Page 4: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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… 18-4

Page 5: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

From Short Run to Long Run

Qf Q2Q3

P3

P1

P2

P3

P1

P2

AS1

Real Domestic Output Real Domestic Output

Qf

Short-RunAggregate Supply

Long-RunAggregate Supply

a1

a2

a3

a1

a2

a3

b1

c1

Pri

ce L

evel

Pri

ce L

evel

AS3

AS2 AS1

ASLR

18-5

Page 6: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Extended AD-AS Model

Real Domestic Output

Long Run Equilibrium

Pri

ce L

evel

P1

Qf

a

AS1ASLR

AD1

18-6

Page 7: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Extended AD-AS Model

Real Domestic Output

Demand-Pull Inflation

Pri

ce L

evel

P1

Qf

a

AS1ASLR

AD1

AD2

AS2

b

cP2

P3

Q2

18-7

Page 8: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Extended AD-AS Model

Real Domestic Output

Cost-push inflation

Pri

ce L

evel

P1

Qf

a

AS1ASLR

AD1

AD2

AS2

b

c

P2

P3

If government counters recession with spending…

If government ignores recession…

Q2

18-8

Page 9: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Extended AD-AS Model

Real Domestic Output

Recession

Pri

ce L

evel P1

Qf

a

AS1ASLR

AD1

AD2

AS2

b

c

P2

P3

Q1

18-9

Page 10: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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

18-10

Page 11: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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 tradeoff18-11

Page 12: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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)

The Phillips Curve

• Demonstrates short-run tradeoff between inflation and unemployment

69

68

6766

65

64

6362

61

Concept Empirical DataData for the 1960s

18-12

Page 13: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Underlying rationale of the Phillips Curve

Real Domestic Output

Pri

ce L

evel

0

P0

P1

P2

P3

Q0 Q1 Q2 Q3

AD0

AD1

AD2

AD3

AS

The Phillips Curve

18-13

Page 14: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

• 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

18-14

Page 15: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

• No long-run tradeoff between inflation and unemployment

• Short-run Phillips curve

–Role of expected inflation

• Long-run vertical Phillips curve

• Disinflation

The Phillips Curve

18-15

Page 16: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

The Long-Run Phillips Curve

3 4 5 60

3

6

9

12

15

An

nu

al R

ate

of

Infl

atio

n (

Per

cen

t)

Unemployment Rate (Percent)

PCLR

PC3

PC2

PC1

a1

b1

a2

a3

b2

b3

c3

c2

18-16

Page 17: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Taxes and Aggregate Supply

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

Tax

Rat

e (P

erce

nt)

Tax Revenue (Dollars)

100

m

0

n

l

m

Laffer Curve

MaximumTax Revenue

18-17

Page 18: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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

18-18

Page 19: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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

18-19

Page 20: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Terms

• short run

• long run

• Phillips Curve

• stagflation

• aggregate supply shocks

• long-run vertical Phillips Curve

• disinflation

• supply-side economics

• Laffer Curve18-20

Page 21: Extending the Analysis of Aggregate Supply Chapter 18 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Current Issues in Macro Theoryand Policy

18-21


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