EXTENDING THE ANALYSIS OF

AGGREGATE SUPPLY

Chapter 35

There are 3 goals for this chapter.Extend the analysis of (AS) to the long runExamine the inflation- unemployment relationshipEvaluate the effect of taxes on (AS)

From Short Run to Long Run

In chapter 29, we noted that in macroeconomics the difference between the short run and the long run has to do with the flexibility of input prices.

Input prices are fixed in the short run, but flexible in the long run. By contrast, output prices are assumed to be fully flexible in both the short run and the long run.

Price level

Real GDP

SRAS

Short Run AS Curve

Price level LRAS

QfLong Run AS curve

Output occurs at the economies full employment level of output or the natural rate of unemployment of 4-5%.

Short Run (AS) Looking at the (SRAS) graph below, we will make 2 assumptions.The initial price level is P1Firms and workers have established nominal wages on the expectation that this price level will persistThe price level is flexible both upward and downward

Observe from point (a1) that at price level (P1) the economy is operating at its full employment output (Qf). Changes in the price level, say, from (P1) to (P2) in the graph below will increase firm’s revenues, and because nominal wages and other input prices remain unchanged, their profits rise.

Those higher profits lead firms to increase their output from (Qf) to (Q2), and the economy moves from a1 to a2 on the aggregate supply curve (AS1). The nation’s unemployment rate declines below its natural rate of 4.5%.

If the price level falls from (P1) to (P3), the opposite scenario will occur.Think through what would happen to output and the unemployment rate.

Price level

Real GDP

SRASP2

P1

P3

QfQ3 Q2

a1

a2

a3

Short Run Aggregate Supply

Long Run (AS)The outcomes are different in the long run. We again suppose the economy is initially at point (a1) at (P1), (Qf). As just demonstrated, an increase in the price level from (P1) to (P2) will move the economy from point (a1) to (a2) along the short run (AS) curve (AS1). At (a2), the economy is producing at more than its potential output.

This implies very high demand for productive inputs, so that input prices begin to rise. In particular, the high demand for labor will drive up nominal wages, which increase per unit production costs.

As a result, the short run (AS) curve shifts leftward from (AS1) to (AS2), which now reflects the higher price level (P2) and the new expectation that (P2), not (P1), will continue.

The economy has moved from (a1), to (a2), to (b1). Real output falls back to the full employment level (Qf) and the unemployment rate rises to its natural rate.

Key Point: In the short run both output and price level change but in the long run only the price level changes.

Price level

Real GDP

LRAS

Qf

SRAS1

SRAS2

SRAS3P2

P1

P3

a1

b1

c1

a2

a3

A decline in the price level from (P1) to (P3) in the graph works in the opposite way from a price level increase. At first the economy moves from point (a1) to (a3) on (AS1). Profits are squeezed because prices have fallen and nominal wages have not.

As time passes, input prices will begin to fall because the economy is producing at below its full employment output level. With less output produced, there is less demand for inputs and their prices will begin to fall. The low demand for labor will drive down nominal wages and reduce per unit production costs.

Lower nominal wages shift the short run (AS) curve rightward from (AS1) to (AS3), and real output returns to its full employment level of (Qf) at point (c1). By tracing a line between the long run equilibrium points (b1), (a1), and (c1), we obtain a long run (AS) curve.

Long Run Equilibrium Long run equilibrium occurs where the (AD) curve, the vertical long run (AS) curve, and the short run (AS) curve all intersect at (Qf). The economy’s natural rate of unemployment prevails, meaning that the economy achieves full employment. In the U.S., output (Qf) implies a 4 to 5% unemployment rate.

Price Level

Real GDP

SRAS

AD1

LRAS

Qf

P1

Remember in the short run, equilibrium occurs wherever the down-sloping (AD) curve and up-sloping (AS) curve intersect. This can be at any level of output, not simply the full employment level. Either a negative GDP gap or a positive GDP gap is possible in the short run.

Applying the Extended AD-AS ModelLet’s look at the long run effects of demand-pull inflation, cost-push inflation and recession.

1) Demand Pull Inflation- Recall that demand pull inflation occurs when an increase in (AD) pulls up the price level. The graph below shows how the adjustment process works. Assume that (AD) increases from (AD1) to (AD2) because one of our demand determinants changed.

The price level rises from (P1) to (P2) and output expands to (Q2), beyond the full employment level of output. So far, this is strictly short run. With the economy producing above potential output, inputs will be in high demand.

Input prices including nominal wages will rise. As they do, the short run (AS) curve will shift leftward such that it intersects long run (AS) at point (c).

The economy has reestablished long run equilibrium, with the price level and real output now (P3) and (Qf) respectively. In the short run, demand pull inflation drives up the price level and increases real output: in the long run, only the price level rises.

Price Level

Real GDP

LRAS

AD1

SRAS1

P1

Qf

AD2

P2

Q2

a

b

SRAS2

P3 c

2) Cost-Push Inflation- arises from factors that increase the cost of production at each price level, shifting the (AS) curve leftward and raising the equilibrium price level. The graph below illustrates this scenario.

Again, assume the economy is operating at price level (P1) and real output level (Qf), at point (a). Suppose international oil producers agree to reduce the supply of oil to boost its price. As a result, per unit production costs of producing and transporting goods and services rises.

This increase in costs shifts the (AS) curve to the left from (AS1) to (AS2). Output falls to (Q2) at point (b).

Cost push inflation creates a dilemma for policymakers.

Without some expansionary policy, (AD) remains in place at (AD1). Government can counter this recession, negative GDP gap, by using fiscal or monetary policy to increase (AD) to (AD2). But there is a potential policy trap here: An increase in (AD) to (AD2), will further raise inflation by increasing the price level from (P2) to (P3).

Price Level

Real GDP

LRAS

AD1

SRAS1

P1

Qf

a

SRAS2

P2

Q2

b

AD2

cP3

In returning the economy to full employment the government has to live with higher inflation. What do you think happens next? (The SRAS curve will shift to the left again pushing the economy into another recession but with even more inflation. If the government repeats its previous policy, the result is a wage-price spiral which continues on and on).

Suppose government decides instead to allow the cost push inflation to run its course. Widespread layoffs, plant shutdowns, and business failures eventually occur. At some point the demand for oil, labor, and other inputs will decline so much that nominal wages will decline.

When that happens, the initial leftward shift of the short run (AS) curve will reverse itself. The price level will return to (P1), and the full employment level of output will be restored at (Qf) on the long run (AS) curve.

Price Level

Real GDP

LRAS

AD1

SRAS1

aP1

Qf

SRAS2

P2

Q2

b

If the government takes a hands-off approach to cost-push inflation, the recession will linger. Although falling input prices will eventually undo the initial rise in per unit production costs, the economy in the meantime will experience high unemployment and a loss of real output.

3) Recession- By far the most controversial application of the extended AD-AS model is its application to recession caused by a decrease in (AD). The graph below illustrates this scenario.

Suppose (AD) initially is (AD1) and that the short run and long run AS curves are (AS1) and (LRAS), respectively. As shown by point (a), the price level is (P1) and output is (Qf). Now assume that (AD) falls to (AD2). Real output declines from (Qf) to (Q2), indicating that a recession has occurred.

If we make the controversial assumption that prices and wages are flexible downward, the price level falls from (P1) to (P2). With the economy producing below potential output at point (b), demand for inputs will be low.

Eventually, nominal wages will fall to restore the previous wage rate; when that happens, the short run (AS) curve shifts rightward from (AS1) to (AS2) bringing the economy back to full employment at (Qf), and a price level of (P3).

Price Level

Real GDP

LRAS SRAS1

AD1

P1

Qf

a

AD2

P2

Q2

b

SRAS2

P3 c

The key point of dispute revolves around the degree to which both input and output prices may be downwardly inflexible and how long it would take in the actual economy for the necessary downward price and wage adjustments to occur to regain the full employment level of output.

For now, suffice it to say that most economists believe that if such adjustments are forthcoming, they will occur only after the economy has experienced a relatively long lasting recession with its accompanying high unemployment and large loss of output.

Economic Growth w/ Ongoing Inflation Both (AD) and (LRAS) increase over time in the actual economy, and inflation occurs because the increases in (AD) generally exceed the increases in (LRAS). It will be helpful to examine this point graphically.

Remember that economic growth is driven by supply factors such as improved technologies and access to more and better resources. Economists illustrate economic growth as either an outward shift of the economy’s PPF or as a rightward shift of its (LRAS) curve.

Capital Goods

Consumer Goods

A

B

C

D0

Outward Shift in the PPF Curve

Price Level

Real GDP

LRAS1 LRAS2

Q1 Q2

Let’s transfer this rightward shift of the economy’s (LRAS) curve to the graph below which depicts economic growth in the U.S. in context of the extended AD-AS model. Assume that economic growth shifts the (LRAS) rightward from (LRAS1) to (LRAS2), while the (AD) curve remains at (AD1).

The economy’s potential output will expand as reflected by the increase of available real output from (Q1) to (Q2). With (AD) constant at (AD1), the increase of the (LRAS) curve will lower the price level from (P1) to (P3). Taken alone, expansions of (LRAS) in the economy are deflationary.

But a decline in the price level, such as the one from (P1) to (P3) is not part of the long run U.S. growth experience. The reason is that the nation’s central bank, the Fed, engineers ongoing increases in the nation’s money supply to create rightward shifts of the (AD) curve.

These increases in (AD) would be highly inflationary absent the increases in the (LRAS). But because the Fed usually makes sure that the inflationary rightward shifts of the (AD) curve proceed only slightly faster than the deflationary rightward shifts of the (LRAS) curve, only mild inflation occurs along with economic growth.

When (AD) shifts to the right from (AD1) to (AD2), and at the same time (LRAS) shifts rightward from (LRAS1) to (LRAS2), real output expands from (Q1) to (Q2), and the price level increases from (P1) to (P2).

Price Level

Real GDP

LRAS1

AD1

SRAS1

P1

Q1

LRAS2

P3

SRAS2

AD2

P2

Q2

Inflation-Unemployment Relationship

Are low unemployment and low inflation compatible goals or conflicting goals?

The extended AD-AS model supports 3 significant generalizations relating to these questions.Under normal circumstances, there is a short run trade-off between the rate of inflation and the rate of unemployment.

(AS) shocks can cause both higher rates of inflation and higher rates of unemployment.There is no significant trade-off between inflation and unemployment over long periods of time.

Phillips Curve: suggests an inverse relationship between the rate of inflation and the rate of unemployment as seen in the graph below.

Inflation %

Unemployment Rate %

SRPC

If (AD) ↑, then (Pl)↑ but (Ur)↓. This would move us up along the existing Phillips Curve.

If (AD) ↓, then (Pl) ↓ but (Ur) ↑. This would move us down along the existing Phillips Curve.

The unemployment-inflation experience of the 1970’s and early 1980’s demolished the idea of an always stable Phillips Curve. Notice in most of the years of the 1970’s and early 1980’s, the economy experienced both higher inflation rates and higher unemployment rates, compared to the 1960’s.

What would that look like on our Phillips curve?

The (SRPC) shifted to the right causing higher inflation and higher unemployment rates at the same time.

Inflation rate %

Unemployment Rate %

1960’s1970’s

Early 1980’s

The condition of rising inflation with higher unemployment became known as stagflation.

The cause of this stagflation had to do with (AS) shocks, or sudden and large increases in resource costs, such as oil, which shifted the (AS) curve to the left, distorting the usual inflation-unemployment relationship.

For example

If (AS) ↓, then the (SRPC) shifts to the right.

If (AS) ↑, then the (SRPC) shifts to the left.

Long Run Phillips CurveOur third generalization relating to the inflation-unemployment relationship supports the idea that there is no apparent long run trade-off between inflation and unemployment.

In the long run any rate of inflation is consistent with the natural rate of unemployment prevailing at the time.

Inflation Rate %

Unemployment Rate %

LRPC

5%

SRPC1

3% a1

4%

6% b1 a2

SRPC2

9% b2 a3

SRPC3

12%b3

Suppose in the graph above we start at (SRPC1) and the economy is experiencing 3% inflation and a 5% natural rate of unemployment. Starting at point (a1), we assume nominal wages are set on the assumption that the 3% inflation rate will continue.

But suppose the inflation rate rises to 6%, perhaps because the Fed increased the (AD) curve. If nominal wages are fixed but product prices rise, then business profits increase. Firms respond by hiring more workers and increasing output.

In the short run, the economy moves to (b1), which in contrast to (a1) involves a lower rate of unemployment at 4% and a higher rate of inflation at 6%, but point (b1) is not a stable equilibrium. In the long run wages and other input prices will rise to match the price level increase.

As a result the (SRAS) curve shifts left and the corresponding (SRPC) shifts right to (SRPC2). Unemployment now returns to the natural rate of 5% at point (a2). We now have higher actual and expected rate of inflation of 6% instead of 3%.

The scenario repeats itself if (AD) continues to increase. The vertical line through (a1), (a2) and (a3) shows the long run relationship between unemployment and inflation. Any rate of inflation is consistent with the 5% natural rate of unemployment.

DisinflationThe distinction between the short run Phillips curve and the long run Phillips curve also helps explain disinflation or a reduction in the inflation rate from year to year. Notice in the graph if inflation falls from 9% to 6% we have disinflation. Prices are still rising but not as fast as before.

Taxation and Aggregate Supply (AS)A final topic in our discussion of (AS) is taxation, a key aspect of supply-side economics, which stresses that changes in (AS) are an active force in determining the levels of inflation, unemployment, and economic growth.

Supply side economists say that the enlargement of the U.S. tax system has impaired incentives to work, save, and invest. In their view, high tax rates impede productivity growth and hence slow the expansion of (LRAS).

Supply- siders focus their attention on marginal tax rates, or the tax rate on extra dollars of income, because those rates affect the benefits from working, saving, or investing more.

Supply- siders believe that how long and hard people work depends on the amounts of additional after-tax earnings they derive from their efforts. They say that lower marginal tax rates on earned income induce more work, and therefore increase aggregate inputs of labor. These lower tax rates increase the after-tax wage rate and make leisure more expensive and work more attractive.

For example the increase in productive effort is achieved in many waysBy increasing the number of hours worked per day or week By encouraging workers to postpone retirementBy inducing more people to enter the labor force By motivating people to work harder

In the supply-side view, reductions in marginal tax rates increase the nation’s (AS) and can leave the nation’s tax revenues unchanged or even enlarge them. Thus, supply-side tax cuts need not produce Federal budget deficits.

In the early 1990’s Arthur Laffer suggested we could lower marginal tax rates and raise total tax revenues. His graph below shows how his idea would work in principle.

Tax Rate %

Tax Revenues $

100

M

0Max. Rev.

N

As tax rates increase from 0 to 100%, tax revenues increase from zero to some maximum level at (m) and then fall to zero. Laffer suggested that the U.S. was at a point such as (n) on the curve. At (n), tax rates are so high that production is discouraged to the extent that tax revenues are below the maximum at (m).

If the economy is at (n), then lower tax rates can either increase tax revenues or leave them unchanged.

The Laffer curve and its supply-side implications have been subject to severe criticisms.One fundamental criticism of the Laffer curve relates to the degree to which economic incentives are sensitive to changes in tax rates.

Critics say there is ample evidence showing that the impact of a tax cut on incentives is small, of uncertain direction, and relatively slow to emerge. Some studies indicate that decreases in tax rates lead some people to work more but lead others to work less.

The issue of where we are on the Laffer curve is an empirical question. If we assume that we are at point (n), then tax cuts will increase tax revenues. But if the economy is at any point below (m) on the curve, tax cuts will reduce tax revenues.

Today, there is general agreement that the U.S. economy is operating at a point below (m), rather than above it on the graph above.

Most economists think that the demand-side effects of a tax cut are more immediate and certain than longer-term supply-side effects. If tax cuts are undertaken when the economy is at or near full employment, the increase in (AD) may overwhelm any increase in (AS).

The likely result is inflation or restrictive monetary policy to prevent it. If a tight money policy is used, real interest rates will rise and investment will fall, defeating the purpose of the supply-side tax cut.