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

Chapter 35 - Extending the analysis of aggregate supply. In this chapter, students will be able to understand: Explain the relationship between short-run aggregate supply and long-run aggregate supply; discuss how to apply the extended (short-run/long-run) AD-AS model to inflation, recessions, and economic growth; explain the short-run trade-off between inflation and unemployment (the Phillips Curve);...

Extending the Analysis of

Aggregate Supply

Chapter 35

• The Phillips curve

• No long-run tradeoff between

inflation and unemployment

• Taxes and aggregate supply

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?

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…

From Short Run to Long Run

Long-Run Aggregate Supply

Extended AD-AS Model

Real Domestic Output

Long Run Equilibrium

AS 1

AS LR

AD 1

Extended AD-AS Model

Real Domestic Output

P 2

P 3

Q 2

Extended AD-AS Model

Real Domestic Output

If government counters recession with spending…

If government ignores recession…

Q 2

Extended AD-AS Model

Real Domestic Output

P 2

P 3

Q 1

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

Inflation and Unemployment

• Low inflation and unemployment

–Fed’s major goals

0 1 2 3 4 5 6 7

Unemployment Rate (Percent)

The Phillips Curve

• Demonstrates short-run tradeoff

between inflation and unemployment

69 68

67 66 65 64

63 62 61

Concept Empirical Data

Data for the 1960s

Underlying rationale of 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

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

The Phillips Curve

The Long-Run Phillips Curve

0 3 6 9 12 15

Taxes and Aggregate Supply

• Supply-side economics

• Tax incentives to work

• Tax incentives to save and invest

• The Laffer curve

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

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

• aggregate supply shocks

• long-run vertical Phillips Curve

• disinflation

• supply-side economics

• Laffer Curve

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