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.