CHAPTER 16: ExTENDING THE ANALYSES OF AGGREGATE SUPPLY

• From Short Run to Long Run

Short Run – period in which nominal wages do not respond to price-level changes

• Short-Run Aggregate Supply

Its curve has a positive slope because nominal wages are unresponsive to the price-level changes.

• Long-Run Aggregate Supply

Its curve is vertical, because nominal wages eventually change by the same relative amount in the price level.

• Equilibrium in the Extended AD-AS Model

It occur at the intersection of the aggregate demand curve, the long run aggregate supply curve, and the short run aggregate supply curve.

APPLYING THE ExTENDED AD-AS MODEL

•  Demand-Pull Inflation in the Extended AD-AS Model

In the short run, demand-pull inflation raises both the price level and real output; in the long run, nominal wages rise. The short run aggregate supply curve shifts to the left, and only the price level increases.

• Cost Push Inflation in the Extended AD_AS Model

Cost push inflation creates a policy dilemma for the government. If it engages in an expansionary policy to increase output, an inflationary spiral occur; if it does nothing recession will occur.

• Recession and the Extended AD-AS Model

In the short run, a decline in aggregate demand reduces real output; in the long run, prices and nominal wages presumably fall, the short run aggregate supply curve shifts to the right, and real output returns to its full-employment level.

THE INFLATION-UNEMPLOYMENT RELATIONSHIP

·         Under normal circumstances, there is a short-run tradeoff between the rate of inflation and the rate of unemployment.

·         Aggregate supply shocks can occur both higher rates of inflation and higher rates of unemployment.

·         There is no significant tradeoff between inflation and unemployment over long periods of time.

• The Philipps Curve – a curve showing the relationship between the unemployment rate and the annual rate of increase in the price level.

• Disinflation – reductions in inflation rate from year to year.

TAxATION AND AGGREGATE SUPPLY

Supply-side economics – active force in determining the levels of inflation, unemployment and economic growth.

• Laffer curve – a curve relating government tax rates and tax revenues on which a particular tax rate maximizes tax rates.

• Criticisms on the Laffer Curve

·         Taxes, Incentives and Time

·         Inflation or Higher Real Interest Rates

·         Position on the Curve