35 Extending the Analysis of Aggregate Supply McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
AGENDA Thurs 3/3 Team Teaching: CH 35 (Wrap-up??) P3: Grant, Hannah, Jason, Pedro P5: Ms. K (still) QOD #20: East Compton Practice/Review Handouts On Deck: CH 30 (Thurs) P3: Amanda, Jeyla, Joseph, Vanessa P5: Ms. K (yep, once again) HW: Prep for CH 28, 29, 35 Assessment (Tues) Read pp 613-619 Q#2,3 P#1 LO1 29-2
QOD #20: East Compton Suppose that for years East Compton s short-run Phillips Curve was such that each 1 percentage point increase in its unemployment rate was associated with a 2 percentage point decline in its inflation rate. Then, during several recent years, the short-run pattern changed such that its inflation rate rose by 3 percentage points for every 1 percentage point drop in its unemployment rate. Graphically, did East Compton s Phillips Curve shift upward or did it shift downward? LO1 29-3
QOD #20: East Compton The Phillips Curve shifted upward. This occurs in response to a decrease in the aggregate supply curve. LO1 29-4
FRQ Practice 2012 #3 (SRAS/LRAS-wages) Solution 2013 #3 (Phillips Curve) Solution 2011 #1a,b,c (SRPC/LRPC) Solution 2988
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 35-6
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 35-7
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 35-8
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 35-9
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 35-10
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 LO2 35-11
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 LO2 35-12
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. LO2 35-13
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 LO2 35-14
Inflation and Unemployment Low inflation and unemployment Fed s major goals Compatible or conflicting? See p. 725. Short-run tradeoff Supply shocks cause both rates to rise No long-run tradeoff LO3 35-15
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. LO3 35-16
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 LO4 35-17
Annual rate of inflation (percent) The Phillips Curve 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unemployment rate (percent) LO4 35-18
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) 35-19
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). LO5 35-20