Lecture Economics (18th edition): Chapter 35 - McConnell, Brue, Flynn''s

Chapter 35
Extending the
Analysis of
Aggregate
Supply
McGraw­Hill/Irwin

        Copyright © 2009 by The McGraw­Hill 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 Q 2
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 Qf
Real Domestic Output
35-8

Extended AD-AS Model
Recession

Price Level

ASLR

P3

AS2

a

P1
P2

AS1

b
c
AD1
AD2

Q 1 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

m
l

0

Laffer Curve

Maximum
Tax Revenue

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