Chapter 17: Extending the Analysis of Aggregate Supply and the Phillips Curve

Fundamental Differences Between Short Run and Long Run

• Short Run Characteristics (LO17.1):

  • Input Prices: Described as inflexible or "sticky."

  • Aggregate Supply: The curve is upsloping, reflecting the positive relationship between the price level and real output when input costs are fixed.

• Long Run Characteristics (LO17.1):

  • Input Prices: Described as fully flexible, meaning they can adjust to changes in the price level.

  • Aggregate Supply: The curve is vertical at the potential output level ($Q_f$).

• The Transition Process:

  • The economy moves from the short run to the long run based on how input prices respond to production levels relative to the potential output ($Q_f$).

Dynamic Adjustments from Short Run to Long Run

• Production Above Potential Output (Q > Q_f):

  • Initial State: High demand for inputs characterizes this phase.

  • Price Response: Excessive demand causes input prices (such as wages) to rise.

  • AS Shift: As production costs increase, the short-run aggregate supply ($AS$) curve shifts to the left.

  • Final Outcome: The economy returns to the potential output level at a higher price level.

• Production Below Potential Output (Q < Q_f):

  • High unemployment and low demand for inputs lead to falling input prices.

  • This reduction in costs shifts the short-run aggregate supply curve to the right.

  • The economy eventually returns to potential output at a lower price level.

• Graphical Data (Graph a & b):

  • Initial Equilibrium: Point $a_1$ located at ($Q_f$, $P_1$).

  • Expansion: Moving up the curve to point $a_2$ at ($Q_2$, $P_2$) represents the short run.

  • Contraction: Moving down the curve to point $a_3$ at ($Q_3$, $P_3$).

  • Long-Run Result: Long-run aggregate supply ($AS_{LR}$) is a vertical line at $Q_f$. Higher input prices shift $AS_1$ to $AS_2$ crossing at point $b_1$ ($Q_f$, $P_2$). Lower input prices shift $AS_1$ to $AS_3$ crossing at point $c_1$ ($Q_f$, $P_3$).

Applying the Extended AD-AS Model: Inflation and Recession

• Equilibrium in the Long Run:

  • Occurs where the downward-sloping aggregate demand ($AD_1$), the upward-sloping short-run aggregate supply ($AS_1$), and the vertical long-run aggregate supply ($AS_{LR}$) intersect at point $a$ ($Q_f$, $P_1$).

• Demand-Pull Inflation:

  • Initial Shift: Aggregate demand shifts right from $AD_1$ to $AD_2$.

  • Short-Run Effect: Equilibrium moves from point $a$ ($Q_f$, $P_1$) to point $b$ ($Q_2$, $P_2$).

  • Long-Run Adjustment: As nominal wages rise in response to higher prices, $AS_1$ shifts left to $AS_2$. Equilibrium settles at point $c$ ($Q_f$, $P_3$).

• Cost-Push Inflation:

  • Initial Shift: $AS_1$ shifts left to $AS_2$ due to an increase in per-unit production costs.

  • Outcome: Equilibrium moves from point $a$ ($Q_f$, $P_1$) to point $b$ ($Q_2$, $P_2$) on the $AD_1$ curve.

  • Government Response: If the government increases $AD$ to $AD_2$ to counter unemployment, equilibrium moves to point $c$ ($Q_f$, $P_3$), confirming a higher price level.

• Recession in the Extended Model:

  • Initial Shift: $AD_1$ shifts left to $AD_2$.

  • Short-Run Effect: Equilibrium moves from point $a$ ($Q_f$, $P_1$) down to point $b$ ($Q_1$, $P_2$).

  • Long-Run Adjustment: If prices and wages are flexible downward, $AS_1$ shifts right, eventually returning equilibrium to $Q_f$ at a lower price level, point $c$ ($P_3$).

Economic Growth and Ongoing Inflation

• Relationship with Production Possibilities:

  • An outward shift in the production possibilities curve (from points $A, B$ to $C, D$) is equivalent to a rightward shift of the long-run aggregate supply curve from $AS_{LR1}$ to $AS_{LR2}$.

• Explaining Ongoing Inflation:

  • Economic Growth: Shifts aggregate supply rightward.

  • Money Supply Increases: Ongoing increases in the money supply shift aggregate demand rightward at a faster rate than the supply shift.

  • Result: A small, positive rate of inflation consistent with long-term growth.

• U.S. Growth Model Details:

  • $AS_{LR1}$ at $Q_1$ shifts to $AS_{LR2}$ at $Q_2$.

  • Equilibrium moves from ($Q_1$, $P_1$) to ($Q_2$, $P_2$) as both $AS$ and $AD$ shift right, resulting in a higher price level ($P_2$ compared to $P_1$).

The Inflation-Unemployment Relationship

• Major Goals of the Federal Reserve:

  • Low inflation and low unemployment rates.

• The Short-Run Tradeoff:

  • There is a short-run inverse relationship between the rate of inflation and the rate of unemployment, known as the Phillips Curve.

  • When $AD$ increases, real output rises and unemployment falls, but the price level (inflation) rises.

• Aggregate Supply Shocks:

  • These shocks (like oil price increases) cause both inflation and unemployment to rise simultaneously, shifting the Phillips Curve to the right (Stagflation).

• The Phillips Curve Data (1960–2021):

  • 1960s: Economists believed in a stable, predictable tradeoff. Data points from 1961–1969 show a curve moving from ($6.8$, $0.8\%$) upward to ($3.7$, $6\%$).

  • 1970s: The decade of stagflation, primarily caused by the OPEC oil price shock. The Phillips Curve shifted significantly outward.

  • 1980s: Demise of stagflation; the curve began shifting back toward the origin.

  • Misery Index (2010–2021): Defined as the sum of the inflation rate and the unemployment rate. U.S., Italy, France, Canada, and U.K. indices fluctuated between $7$ and $12$; Japan remained lower, ending around $3.5$ in 2020.

The Long-Run vertical Phillips Curve

• No Long-Run Tradeoff:

  • In the long run, there is no tradeoff between inflation and unemployment; the long-run Phillips Curve ($PC_{LR}$) is vertical at the natural rate of unemployment (e.g., $5\%$).

• Role of Expected Inflation:

  • Short-run Phillips Curves ($PC_1, PC_2, PC_3$) exist for different levels of expected inflation.

  • If inflation is $3\%$ and increases to $6\%$, the economy moves from point $a_1$ to $b_1$ (unemployment falls to $4\%$).

  • Once workers expect $6\%$ inflation, nominal wages rise, shifting the curve to $PC_2$, and the economy moves to point $a_2$ ($5\%$ unemployment, $6\%$ inflation).

• Disinflation:

  • Reductions in the inflation rate can lead to temporary increases in unemployment as the economy moves down a short-run Phillips curve before expectations adjust.

Taxation and Aggregate Supply

• Supply-Side Economics:

  • Focuses on how tax changes affect incentives to work, save, and invest.

  • High tax rates are believed to reduce the transition of resources into production, thereby limiting aggregate supply.

• The Laffer Curve:

  • A graph showing the relationship between tax rates and tax revenues.

  • At a $0\%$ tax rate, revenue is $0$. At a $100\%$ tax rate, revenue is also $0$ (because there is no incentive to work).

  • Maximum Revenue: Point $m$ represents the tax rate that maximizes revenue. If current rates are in the range between point $m$ and $100\%$ (e.g., point $n$), cutting tax rates can actually increase tax revenue.

• Criticisms and Evaluations:

  • Incentives and Time: The impact of tax cuts on incentives may be small or take a long time to manifest.

  • Macroeconomic Effects: Tax cuts might lead to higher real interest rates or inflation if they increase the budget deficit.

  • Position on the Curve: Critics argue it is difficult to determine if a nation is actually on the downward-sloping portion of the Laffer Curve.

Last Word: Effects of Tax Increases on Real GDP

• Research Findings (Romer and Romer, 2008):

  • Empirical evidence suggests that tax increases generally reduce real GDP.

  • Investment spending falls sharply in response to tax increases.

• Analytical Difficulties:

  • It is challenging to isolate the effects of tax changes from other economic variables, such as positive output shocks that naturally raise tax revenues regardless of the tax rate.