6: EXTENDED AGGREGATE SUPPLY

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1 6: EXTENDED AGGREGATE SUPPLY CHAPTER 16 SHORT RUN period of time (6 months) where nominal wages and input costs remain fixed as price levels (profits) increase or decrease LONG RUN period in which nominal wages fully respond to price level changes REASONS FOR FIXED SHORT-RUN WAGES - Workers may not immediately notice inflation affecting their wages - Many workers are on fixed contracts and cannot demand raises until contract expires ECONOMIC GROWTH Economic Growth Factors: - Increase in resources - Better resource quality - Technological advances

2 SITUATION: DEMAND-PULL INFLATION A > B : Short run effect B > C : Long run effect Economy begins at GDP1, PL1 but ends at GDP1, PL2. Point C, on each graph, represents the LONG- RUN location in which the economy stabilizes. (LR = Long Run; SR = Short Run) SITUATION: DECREASE IN GDP (RECESSION) Economy begins at GDP1, PL1 but ends at GDP1, PL2

3 SITUATION: COST-PUSH INFLATION Economy begins at GDP1, PL1 but ends at GDP1, PL2 AGGREGATE SUPPLY SHOCKS, or sudden increases in resource costs, is the only situation in which cost-push inflation occurs Because the third situation represents shrinking GDP and increasing price levels, STAGFLATION is occurring The movement along a fixed curve followed by a horizontal shift to intersect with the LRAS is what depicts the RATCHET EFFECT Suppose the government wanted to use EXPANSIONARY FISCAL POLICY to increase GDP to combat C-P inflation. The AD curve would shift rather than the second AS curve, causing prices to not be at level 2 but rather level 3 The Long-Run effects of the initial three situations show no government intervention, keeping prices at a higher of PL2

4 PHILLIPS CURVE A direct reflection of the prior graph but with different axes and lacks a visible AD curve. Effects of AD curve are visible, but not the AD graph itself. EXACT SAME EFFECTS OF PREVIOUS GRAPHS ARE DEPICTED ON PHILLIPS CURVE, but leftward shifts are rightward shifts on the Phillips Curve. The PC curve is the reflection of the AS curve of the previous graph. LAFFER CURVE Any part of the curve above A is based completely on human incentive to work This supply-side economics curve was based on the reasoning that lower tax rates stimulate incentive to work, save and invest

5 CRITICISM OF CURVE - Tax cut impact on incentives is miniscule - Demand-side effects of lowering taxes would cause D-P inflation. D-S effects have greater influence than supply-side economics - Economy s location on Laffer Curve is unknown CHAPTER 18 PUBLIC DEBT total accumulation of each year s deficits (minus surpluses) the federal government has incurred over time Represents total amount of money owed by government to holders of U.S. securities/bonds FACTORS THAT CAUSE PUBLIC DEBT War government expenditures increase. Available options to finance spending include: increasing taxes, printing money and borrowing funds Recessions national income declines thus tax revenue declines Tax cuts tax cuts account for much of the growing debt since 1980 and congress failed to cut spending WHY PUBLIC DEBT IS NOT TO BE WORRIED ABOUT Debt & GDP a wealthy and highly productive nation can incur a large public debt than a poorer nation due to debt to GDP ratio Burden only burden of our debt is the minimum payment or interest Interest charges Most of debt is owned by Americans (about 78%) Will not burden future generations POSSIBLE ISSUES OF PUBLIC DEBT Income distribution debt concentrated in wealthy group Payment of interest on debt transfers income from lower income taxpayers to higher income Incentives larger debt results in larger interest. Taxes increasing will hurt incentive to work/invest

6 Foreign ownership GDP output transferred to foreign lenders Crowding-out effect larger debt results in larger interest rate and less investment (but can be negated through government investment on institutions and education BUDGET PHILOSOPHIES 1) Annually balanced budget congress balances budget each year as expenditures much equal revenue. BAD IDEA = fiscal policy is killed. Recessions and inflation worsen because taxes would increase during recessions and surpluses would be created 2) Cyclically balanced budget balance budget over business cycles. Lowered taxes in recession; raised taxes during upswing. Dips are far greater than peaks so it is impossible to fully balance the budget 3) Functional finance balance economy not the budget. The important thing is to provide for noninflationary economy at FE and potential GDP. The government is responsible to achieve stability and growth and not hesitate to get surpluses/deficits in doing so