Extending the Analysis of Aggregate Supply Chapter 16 Short Run Aggregate Supply In macroeconomics this is the period in which wages (and other input prices) remain fixed as price level increases or decreases Long Run Aggregate Supply Period of time in which wages have become fully responsive to changes in price level. Remember how crucial worker salaries to a businesses’ output and bottom line when considering effects on aggregate supply Effects over Short-Run In the short run, price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant. In the long run, wages will adjust to the price level and previous output levels will adjust accordingly Equilibrium in the Extended Model The extended model means the inclusion of both the short run and long run AS curves. The Long AS Curve is represented with a vertical line @ full employment level of real GDP Demand Pull Inflation in the AS Model Demand-Pull – Prices increase based on increase in aggregate demand In the short run, demand pull will drive up prices, and increase production In the long run, increases in aggregate demand will eventually return to previous levels Cost Push & the Extended Model Cost-push arises from factors that will increase per unit costs such as increase in the price of a key resource Short run shifts left. What is important is that in this case, it is the cause of the price level increase, not the effect. Dilemma for the Government In an effort to fight cost-push, the government can react in two different ways. Action such as spending by the Gov’t could begin an inflationary spiral No action however could lead to recession by keeping production and employment levels declining Recession & the Extended Model A recession is signaled on the model by a shift leftward of aggregate demand. Price level will decrease and eventually wages will fall as well. Output then return to the full employment level How long this adjustment takes however is a matter of dispute among economists The Phillips Curve Created by AW Phillips to examine relationship between inflation & unemployment Basic premise is that inflation & unemployment have an inverse relationship The 1970’s however put this theory into serious question due to stagflation – rising unemployment Adverse Aggregate Supply Shocks of the 1970’s What caused increases in both unemployment and inflation? OPEC quadrupled their prices Wages increased, however the dollar lost value, and productivity declined Great stagflation of the “1970’s” made it clear that there was not always an inverse relationship between stable inflation & unemployment Stagflation’s Demise Stagflation – Stagnant economy mixed with high inflation The recession ’81 & ’82 brought this to an end. Tight money policies reduced double digit inflation however led to a higher unemployment rate and a lack of productivity. Wages were also reduced both at home and abroad. Stagflation Demise Cont’d Deregulation of the Airlines as well as the trucking industries also resulted in wage & price reductions OPEC lost a great deal of power which resulted in lower prices for oil. Long-run Vertical Phillips Curve View is that the economy is generally stable at the full-employment level. Hypotheses question the existence of a long run relationship between unemployment and inflation Fully anticipated inflation generates responsiveness by the work force and creates a vertical Phillips Curve. Long-run Vertical Phillips Curve View is that the economy is generally stable at the full-employment level. Hypotheses questions the existence of a long run relationship between unemployment and inflation Fully anticipated inflation generates and responsiveness by the work force creates a vertical Phillips Curve. Interpretations of the Phillips Curve Most economists acknowledge validity in the short-run (2-3 years). Long run tradeoff between inflation and unemployment is much less likely Taxation & Aggregate Supply Supply-side economics maintains that government policy reduces growth in a number of ways 1. Taxation negatively effects incentives to work 2. Taxation limits corporate investment 3. Government transfer programs discourage work The Laffer Curve Named after economist Arthur Laffer. It relates tax rates and tax revenues. States that higher rates of taxation the government higher tax revenues. At some point, revenues will decline due to limitations on productivity. Laffer argued that ultimately you can increase revenues by expanding output through lower taxes Loanable Funds Theory Supply slopes upward – more $$ available at higher interest rates. Most individuals need to be given incentive to save. Demand slopes downward – rate of return on investment projects decreased by high rates. The market is structured in a way that households invest their money with a specific financial institution. The institution then loans the money to businesses.