chapter 16 lras

Extending the Analysis ofAggregate Supply

16C H A P T E R

SHORT-RUN AND LONG-RUNAGGREGATE SUPPLY

Period in which nominal wages (and other input prices) remainfixed as the price level increases or decreases

Short Run -

Period in which nominal wages are fully responsive to previous changes in the price level

Long Run -

o

AS1

P1

P2

Qf Q2

a1

a2

A higher price level increases profits and output moving the economy from a1 to a2.

Pri

ce L

evel

Real domestic output

SHORT-RUN AGGREGATE SUPPLY

o

AS1

P1

P2

Qf

a1

a2

A lower price level decreases profits and output moving the economy from a1 to a3 .

Pri

ce L

evel

Real domestic output

SHORT-RUN AGGREGATE SUPPLY

P3 a3

Q2Q3

o

AS1

P1

P2

Qf

a2

a1

AS2

b1

ASLRP

rice

Lev

el

Real domestic output

LONG-RUN AGGREGATE SUPPLYA higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left .

o

P3

AS1

P1

P2

Qf

a2

a3

a1

AS2

b1

AS3

c1

ASLRP

rice

Lev

el

Real domestic output

LONG-RUN AGGREGATE SUPPLYA lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right .

EQUILIBRIUM IN THEEXTENDED AD-AS MODEL

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

DEMAND-PULL INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

P3

AD2

AS2

c

Q1

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

AS2

Occurs when short-run AS shifts left

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

P3

AD2

AS2

Government response with increased AD

c

Evenhigherpricelevels

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

AS2

If government allows a recession to occur

Q2

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Qf

Pri

ce L

evel

Real domestic output

bP2

AS2

If government allows a recession to occur

Nominal wages fall &AS returns

to its originallocation

THE INFLATION-UNEMPLOYMENTRELATIONSHIP

• Normally, there is a short-run trade-off between the rate of inflation and the the rate of unemployment.

• Aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment.

• There is no significant trade-off over long periods of time.

o

P0

Q0

AD0

AS

EFFECT OF CHANGES IN AGGREGATE DEMANDON REAL OUTPUT AND THE PRICE LEVEL

Pri

ce L

evel

Real domestic output

o

P0

P1

Q0 Q1

AD0 AD1

AS

EFFECT OF CHANGES IN AGGREGATE DEMANDON REAL OUTPUT AND THE PRICE LEVEL

Pri

ce L

evel

Real domestic output

o

P0

P1

P2

Q0 Q1 Q2

AD0 AD1 AD2

AS

EFFECT OF CHANGES IN AGGREGATE DEMANDON REAL OUTPUT AND THE PRICE LEVEL

Pri

ce L

evel

Real domestic output

o

P0

P1

P2

P3

Q0 Q1 Q2 Q3

AD0 AD1 AD2 AD3

AS

EFFECT OF CHANGES IN AGGREGATE DEMANDON REAL OUTPUT AND THE PRICE LEVEL

Pri

ce L

evel

Real domestic output

An

nu

al r

ate

of in

flat

ion

(per

cen

t)

Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

As inflation declines...

THE PHILLIPS CURVE CONCEPT

unemploymentincreases

1997

15

10

5

01992 2002

U.K.

GLOBAL PERSPECTIVEThe Misery Index, Selected Nations 1992 - 2002

Source: Bureau of Labor Statistics

Canada

Italy

France

U.S.

Germany

Japan

THE LONG-RUN PHILLIPS CURVE

Aggregate-Supply Shocks

Stagflation’s Demise

Short-Run Phillips Curve

Long-Run Vertical Phillips Curve

Disinflation

TAXATION AND AGGREGATE SUPPLY

Supply-Side Economics

Taxes and Incentives to Work

Incentives to Save and Invest

Laffer Curve

0

100

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m

n

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m m

n

l

THE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

MaximumTax

Revenue

Criticisms of the Laffer Curve

Taxes, Incentives, and Time

Inflation or Higher Interest Rates

Position on the CurveRebuttal and Evaluation

Up next...

Economic Growth

Chapter 17