Transcript Extending the Analysis of Aggregate Supply

Extending the Analysis of
Aggregate Supply
Chapter 18
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From Short Run to Long Run
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Short-Run
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Two reasons why nominal wages may for a time be unresponsive
to changes in price level
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Workers may not immediately be aware of the extent to which
inflation has changed their real wages, and thus they may not adjust
their labor supply decisions & wage demands accordingly
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Many employees are hired under fixed-wage contracts (I.e. unionized
workers)…
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Price level changes do not immediately give rise to changes in
nominal wages
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Once labor contracts expire, wages can be adjusted
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Long-Run
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Once contracts have expired and nominal
wages have been adjusted, the economy
enters the long run

Nominal wages are fully responsive to
previous changes in price level
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Short-Run AS
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Nominal wages do not respond to price-level
changes based on the expectation that price
level (p1) will continue.
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An increase in price level increases prices &
profits & output
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A decrease in price level reduces profits &
real output
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Long-Run AS
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A rise in the price level results in higher nominal
wages
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Decrease in price level reduces nominal wages
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AS curve shifts to left
AS curve shifts to right
After such adjustments, the economy obtains
equilibrium at a different point on the curve
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LR AS curve is vertical
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Long-Run Equilibrium in the AD-AS
Model
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SRAS curve adjusts
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After those adjustments, long-run equilibrium
occurs where all three curves intersect
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Demand-Pull Inflation in the
Extended AD-AS Model
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An increase in the price level eventually leads to an increase in
nominal wages
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SRAS curve will shift left
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Real output will return to its prior level and price level rises even
more
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In this scenario, the economy moves from a to b and then
eventually to c.
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In the short run, demand-pull inflation drives up the price level &
increases real output; in the long run, only the price level rises
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Cost-Push Inflation in the Extended
AD-AS Model
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Occurs when the SRAS curve shifts leftward
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If government counters the decline in real output by
increasing AD, the price level will rise even more
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In contrast, if government allows a recession to
occur (I.e. no increase in AD), nominal wages fall
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AS curve shifts back to original location
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Recession & the Extended AD-AS
Model
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A recession occurs when AD shifts left
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If prices & wages are downwardly flexible, the price level
falls
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The decline in price level eventually reduces nominal
wages & shifts AS curve to right
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Price level continues to decline, but real output increases
back to original output (neg. GDP gap evaporates w/no
need for expansionary fiscal or monetary policy)
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The Inflation-Unemployment Relationship
Important because low inflation & unemployment
are major economic goals.

Are they compatible or conflicting?
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Three generalizations
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1.
Under normal circumstances, there is a SR trade-off between
the inflation & unemployment rates
2.
AS shocks can cause both higher rates of inflation & higher rates
of unemployment
3.
No significant tradeoff between inflation & unemployment over
long periods of time
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Phillips Curve
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Demonstrates the SR trade-off between the
inflation & unemployment rates
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Inverse relationship between the two
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I.E. lower unemployment rates are associated
with higher rates of inflation
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SR effect of changes in AD on real
output & price level
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The larger the increase in AD, the higher the
inflation rate & the greater increase in real
output.
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Real output & unemployment move in
opposite directions
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High inflation rates should be accompanied
by low rates of unemployment
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AS Shocks & the Phillips Curve
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Unemployment-inflation experience of the 1970’s & early
1980’s ruined the idea of an always-stable Phillips Curve.
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Adverse AS Shocks
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Inflation & unemployment rose simultaneously (stagflation)
Sudden, large increases in resource costs (I.E. crude oil) that
shift the SR AS to the left
Causes stagflation
Stagflation’s demise
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From 1982-89, there was an inward movement of the inflationunemployment points (many wage & price reductions during this
period)
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Led to lower Inflation & unemployment rates
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Misery Index
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Sum of nation’s unemployment & inflation
rates
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Measure of national economic discomfort
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When this figure rises during an election year,
the incumbent political party struggles to get
re-elected
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The Long-Run Phillips Curve
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The overall set of data points on the Phillips Curve
show that there is no apparent long-run tradeoff
between inflation & unemployment
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Short-Run Phillips Curve
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Increases in AD may temporarily boost profits, output, &
employment (a1 to b1)
Wages will catch up, profits will eventually fall. Move from
b1 to a2 (new phillips curve)
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Long-Run Vertical Phillips Curve
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Vertical line through a1, a2, & a3 shows the LR
relationship between inflation & unemployment
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Point b1 is not a stable equilibrium
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Wages will increase to restore lost purchasing
power
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Business profits will fall to their prior level
Unemployment will rise but inflation will not change
Disinflation - Reductions in inflation from year to year
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Taxation and Aggregate Supply
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Supply-side economics (supply-siders)
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Changes in AS are an active force in determining the levels of
inflation, unemployment, & economic growth
Government policies can either impede or promote rightward shifts
of the SR & LR AS curves
Taxes & incentives to work
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Enlargement of the U.S. tax system has impaired incentives to work,
save, & invest
High tax rates impede productivity growth & slow the expansion of
LR AS.
Supply-siders believe that how long & hard people work depends on
the amounts of additional after-tax earnings they get for their efforts
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Incentives to save & invest
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High tax rates reduce the rewards for saving &
investing.
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Lower tax rates encourage saving & investing
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Workers find themselves equipped with more &
technologically superior machinery & equipment
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Labor productivity rises
LRAS will expand and economy will grow as well
Unemployment & inflation rates will be low
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The Laffer Curve
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Shows the relationship between tax rates & tax revenues
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Up to point m, higher tax rates will result in larger tax
revenues
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Tax rates higher than m will adversely affect incentives to
work & produce reducing the size of the tax base
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Criticisms
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Taxes, incentives, & time – Does lower taxes really make people
want to work harder?
Inflation or higher real interest rates – tax cuts may cause demandpull inflation
Position on the curve
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