Extending the Analysis of Aggregate Supply
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1 35 Extending the Analysis of Aggregate Supply McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
2 AGENDA Tues 3/1 Team Teaching: CH 35 P3: Grant, Hannah, Jason, Pedro P5: Ms. K (still) QOD #19: Practice/Review Handouts On Deck: CH 30 (Mon/Tues/Thurs???) P3: Amanda, Jeyla, Joseph, Vanessa P5: Ms. K (yep, once again) HW: Read pp Q#7,8,9 LO1 29-2
3 QOD #19: Busterville Suppose that over a 30-year period Busterville s price level increased from 72 to 138, while its real GDP rose from $1.2 trillion to $2.1 trillion. Did economic growth occur in Busterville? If so, by what average yearly rate in percentage terms (rounded to one decimal place)? Did Busterville experience inflation? If so, by what average yearly rate in percentage terms (rounded to one decimal place)? Which shifted rightward faster in Busterville : its long-run aggregate supply curve (ASLR) or its aggregate demand curve (AD)? LO1 29-3
4 QOD #19: Busterville solution Yes, Buskerville enjoyed economic growth of 75 percent over 30 years, for an average yearly rate of 2.5 percent real GDP growth. Buskerville also experienced inflation of 91.7 percent over 30 years, for an average yearly rate of 3.1 percent. Aggregate demand increased more than aggregate supply, as evidenced by an increase in the price level. LO1 29-4
5 From Short Run to Long Run Short run Input prices inflexible Upsloping aggregate supply Long run Input prices fully flexible Vertical aggregate supply The transition? LO1 35-5
6 From Short Run to Long Run Production above potential output: High demand for inputs Input prices rise so Short run aggregate supply shifts left Return to potential output Production below potential output- input prices fall (assuming wages are flexible downward) Graphical examples LO1 35-6
7 Price Level Price Level From Short Run to Long Run Short-Run Aggregate Supply Long-Run Aggregate Supply P 2 a 2 AS 1 P 2 AS LR b 1 AS 2 AS 1 AS 3 a 2 P 1 a 1 P 1 a 1 P 3 a 3 P 3 a 3 c 1 Q 3 Q f Q 2 Q f Real Domestic Output Real Domestic Output LO1 35-7
8 Price Level From Short Run to Long Run Long Run Equilibrium AS LR AS 1 P 1 a AD 1 Q f Real Domestic Output LO1 35-8
9 Price Level Extended AD-AS Model Demand-Pull Inflation- Where do workers come from? AS LR AS 2 AS 1 P 3 P 2 P 1 c a b AD 1 AD 2 Q f Q 2 Real Domestic Output LO2 35-9
10 Price Level Extended AD-AS Model Cost-Push Inflation- Policy Dilemna? AS LR AS 2 AS 1 P 3 P 2 P 1 b c a AD 1 AD 2 Q 2 Q f Real Domestic Output LO
11 Price Level Extended AD-AS Model Recession AS LR AS 1 AS 2 P 1 P 2 P 3 b a c AD 1 AD 2 Q 1 Q f Real Domestic Output LO
12 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 See p.724. LO
13 Capital Goods Price Level Economic Growth, Ongoing Inflation Productions Possibilities Long Run Aggregate Supply Consumer Goods Increase in production possibilities Real GDP Increase in long-run aggregate supply LO
14 Inflation and Unemployment Low inflation and unemployment Fed s major goals Compatible or conflicting? See p Short-run tradeoff Supply shocks cause both rates to rise No long-run tradeoff LO
15 The Phillips Curve 1960s economists believed in stable, predictable tradeoff Phillips curve shifts over time- more inflation and unemployment Adverse supply shocks 1970s OPEC oil price shock Stagflation Stagflation s demise 1980s-Fed raised interest rates to combat inflation. This helped to lead to recession in the early 1980s. See p.727. LO
16 The Phillips Curve No long-run tradeoff between inflation and unemployment Short-run Phillips curve Role of expected inflation Long-run vertical Phillips curve-see diagram Disinflation LO
17 Annual rate of inflation (percent) The Phillips Curve Unemployment rate (percent) LO
18 Tax Rate (Percent) Taxes and Aggregate Supply Supply-side economics Tax incentives to work Tax incentives to save and invest The Laffer curve 100 n Laffer Curve m m l Maximum Tax Revenue LO5 0 Tax Revenue (Dollars) 35-18
19 Taxes and Aggregate Supply Criticisms of the Laffer curve Taxes, incentives, and time- no real increase in incentive- some people will see they have more after-tax money and work LESS hard. Inflation and higher real interest rates- if AD is at or near full-employment then it is likely to see inflation. Position on the curve- where the economy is on the curve is significant if you even agree with the curve Rebuttal and evaluation-cutting taxes lead to higher revenues. PROBLEM: if you don t cut spending, then you will have HUGE deficits with huge tax cuts(i.e. under Reagan and G.W. Bush). LO
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chapter: Aggregate Demand and Aggregate Supply Aggregate Demand The Aggregate Demand Curve The Aggregate Demand Curve
>> chapter: 1 Demand and Supply Krugman/Wells WHAT YOU WILL LEARN IN THIS CHAPTER " How the demand curve illustrates the relationship between the and the quantity of output demanded in the economy " How