This document discusses short-run and long-run aggregate supply. In the short-run, nominal wages are fixed as the price level increases or decreases. In the long-run, nominal wages are fully responsive to previous price level changes. The document uses graphs to illustrate how higher or lower price levels can shift short-run aggregate supply curves left or right, and how this leads to changes in output. It also discusses cost-push inflation, the inflation-unemployment relationship, and the effects of aggregate demand changes on price levels and output.

1. Extending the Analysis of Aggregate Supply 16 C H A P T E R

2. SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Short Run - Period in which nominal wages are fully responsive to previous changes in the price level Long Run -

3. o AS 1 P 1 P 2 Q f Q 2 a 1 a 2 A higher price level increases profits and output moving the economy from a 1 to a 2 . Price Level Real domestic output SHORT-RUN AGGREGATE SUPPLY

4. o AS 1 P 1 P 2 Q f a 1 a 2 A lower price level decreases profits and output moving the economy from a 1 to a 3 . Price Level Real domestic output SHORT-RUN AGGREGATE SUPPLY P 3 a 3 Q 2 Q 3

5. o AS 1 P 1 P 2 Q f a 2 a 1 AS 2 b 1 AS LR Price Level Real domestic output LONG-RUN AGGREGATE SUPPLY A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left .

6. o P 3 AS 1 P 1 P 2 Q f a 2 a 3 a 1 AS 2 b 1 AS 3 c 1 AS LR Price Level Real domestic output LONG-RUN AGGREGATE SUPPLY A lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right .

7. EQUILIBRIUM IN THE EXTENDED AD-AS MODEL o P 1 AS 1 AS LR AD 1 a Q f Price Level Real domestic output

8. DEMAND-PULL INFLATION o P 1 AS 1 AS LR AD 1 a Q f Price Level Real domestic output b P 2 P 3 AD 2 AS 2 c Q 1

9. Q 2 COST-PUSH INFLATION o P 1 AS 1 AS LR AD 1 a Q f Price Level Real domestic output b P 2 AS 2 Occurs when short-run AS shifts left

10. Q 2 COST-PUSH INFLATION o P 1 AS 1 AS LR AD 1 a Q f Price Level Real domestic output b P 2 P 3 AD 2 AS 2 Government response with increased AD c Even higher price levels

11. COST-PUSH INFLATION o P 1 AS 1 AS LR AD 1 a Q f Price Level Real domestic output b P 2 AS 2 If government allows a recession to occur Q 2

12. Q 2 COST-PUSH INFLATION o P 1 AS 1 AS LR AD 1 a Q f Price Level Real domestic output b P 2 AS 2 If government allows a recession to occur Nominal wages fall & AS returns to its original location

14. o P 0 Q 0 AD 0 AS EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL Price Level Real domestic output

15. o P 0 P 1 Q 0 Q 1 AD 0 AD 1 AS EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL Price Level Real domestic output

16. o P 0 P 1 P 2 Q 0 Q 1 Q 2 AD 0 AD 1 AD 2 AS EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL Price Level Real domestic output

17. o P 0 P 1 P 2 P 3 Q 0 Q 1 Q 2 Q 3 AD 0 AD 1 AD 2 AD 3 AS EFFECT OF CHANGES IN AGGREGATE DEMAND ON REAL OUTPUT AND THE PRICE LEVEL Price Level Real domestic output

18. Annual rate of inflation (percent) Unemployment rate (percent) 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 As inflation declines... THE PHILLIPS CURVE CONCEPT unemployment increases

19. 1997 15 10 5 0 1992 2002 GLOBAL PERSPECTIVE The Misery Index, Selected Nations 1992 - 2002 Source: Bureau of Labor Statistics U.K. Canada Italy France U.S. Germany Japan

20. THE LONG-RUN PHILLIPS CURVE Aggregate-Supply Shocks Stagflation’s Demise Short-Run Phillips Curve Long-Run Vertical Phillips Curve Disinflation

21. TAXATION AND AGGREGATE SUPPLY Supply-Side Economics Taxes and Incentives to Work Incentives to Save and Invest Laffer Curve

22. 0 100 l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

23. 0 100 m l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

24. 0 100 m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

25. 0 100 m m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent) Maximum Tax Revenue

26. Criticisms of the Laffer Curve Taxes, Incentives, and Time Inflation or Higher Interest Rates Position on the Curve Rebuttal and Evaluation

27. Up next... Economic Growth Chapter 17