Chapter 18 – Extending the Analysis of Aggregate Supply
CHAPTER EIGHTEEN
EXTENDING THE ANALYSIS OF AGGREGATE SUPPLY
CHAPTER OVERVIEW
This is the first chapter of Part nine, “Extensions and Issues.” This chapter explains the difference
between long-run and short-run aggregate supply; it examines the unemployment-inflation relationship
and assesses the effect of taxes on aggregate supply.
WHAT’S NEW
There are no major content changes to this chapter.
The only addition is a new paragraph on Supply-Side economics and the “Laffer Curve”, followed by new
Quick review at the end of the chapter.
All relevant tables and graphs have been updated with current data.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Explain the difference between the short-run and long-run aggregate supply curves and their
significance for economic policy.
2. Distinguish between demand-pull and cost-push inflation using the extended aggregate demand-
aggregate supply model.
3. Explain and construct a traditional short-run Phillips Curve using the aggregate demand-aggregate
supply model.
4. Differentiate between the short-run and long-run Phillips Curves.
5. Identify the supply-side shocks to the U.S. economy in the 1970s and 1980s.
6. Use an aggregate demand-aggregate supply graph to show how supply-side shocks led to
stagflation in the 1970s and 1980s.
7. Explain why we may observe continued levels of inflation in the economy using the AD-AS model.
8. Explain why demand-management policies cannot eliminate stagflation.
9. Explain two possible effects of taxation on aggregate supply.
10. Explain the Laffer Curve concept and list three criticisms of this theory.
11. Define and identify terms at the end of the chapter.
18-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
COMMENTS AND TEACHING SUGGESTIONS
1. The Phillips Curve controversy can be introduced by using actual data such as that shown in Figure
18.8b and 18.9. Ask students if they can see any discernible pattern between unemployment and
inflation data without viewing the curves.
2. The aggregate supply and demand model can also be helpful in explaining why demand
management policies might entail supply-side effects that limit the attainment of policy goals. The
shifts in Figures 18.4 and 18.5 illustrate this problem.
3. Demand-pull and cost-push inflation were introduced earlier, so they should be familiar. However,
a review of the aggregate demand and supply model would be a useful way to begin the discussion.
Explain that it is difficult to distinguish the two types of inflation in the real world, since the causes
of inflation are complex. Use Figure 18.3 and 18.4 to illustrate.
4. A speaker who can recall a time or country where wage-price controls were used, and the problems
associated with them might be interesting for students, who might otherwise believe these controls
are a simple solution.
5. Throughout the discussion of the Phillips Curve, be sure to point out that the vertical axis measures
changes in the price level, not the price level itself (as in AD-AS model).
STUDENT STUMBLING BLOCKS
1. Students may not see why employment usually declines when policies to reduce inflation are
implemented.
2. Students may have difficulty with the extended AD-AS model. Have them review Figure 18.1
carefully. Current events may give practice in deciding how the event will impact the economy,
through the demand side or the supply side. For example, the impact of tax cuts made in 2001 and
2003 could be analyzed, as could oil supply disruptions caused by Middle East conflict.
LECTURE NOTES
I. Introduction
A. Learning objectives – After reading this chapter, students should be able to:
1. Explain the relationship between short-run aggregate supply and long-run aggregate
supply.
2. Discuss how to apply the “extended” (short-run/long-run) AD-AS model to inflation,
recessions, and economic growth.
3. Explain the short-run tradeoff between inflation and unemployment (the Phillips Curve).
4. Discuss why there is no long-run trade off between inflation and unemployment.
5. Explain the relationship between tax rates, tax revenues, and aggregate supply.
B. Recent focus on the long-run adjustments and economic outcomes has renewed debates about
stabilization policy and causes of instability.
C. This chapter makes the distinction between short run and long run aggregate supply.
D. The extended model is then used to glean new insights on demand-pull and cost-push
inflation.
E. The relationship between inflation and unemployment is examined; we look at how
expectations can affect the economy, and assess the effect of taxes on aggregate supply.
18-2
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
II. Short-Run and Long-Run Aggregate Supply
A. Definition: Short-run and long-run.
1. For macroeconomics the short-run is a period in which wages (and other input prices) do
not respond to price level changes.
a. Workers may not be fully aware of the change in their real wages due to inflation (or
deflation) and thus have not adjusted their labor supply decisions and wage demands
accordingly.
b. Employees hired under fixed wage contracts must wait to renegotiate regardless of
changes in the price level.
2. Long run aggregate supply (See Figure 18.1b). Formed by long-run equilibrium points
a1, b1, c1.
a. In the long run, nominal wages are fully responsive to price level changes.
b. The long run aggregate supply curve is a vertical line at the full
employment level of real GDP. (See Figure 18.1b) (b1, a1, c1).
B. Short-run aggregate supply curve AS1, (see Figure 18.1a)
1. The curve is constructed with three assumptions.
a. The initial price level is given at P1.
b. Nominal wages have been established on the expectation that this specific price level
will persist.
c. The price level is flexible both upward and downward.
2. If the price level rises, higher product prices with constant wages will bring higher profits
and increased output. (See Figure 18.1a) (The economy moves from a1 to a2 on curve
AS1.)
3. If the price level falls, lower product price with constant wages will bring lower profits
and decreased output. (See Figure 18.1a) (The economy moves from a1 to a3 on curve
AS1.)
C. The extended AD-AS makes the distinction between the short run and long run aggregate
supply curves. (See Figure 18.2) Equilibrium occurs at point a where aggregate demand
intersects both the vertical long run supply curve and the short run supply at full employment
output.
III. Applying the Extended AD-AS Model
A. Demand-pull inflation: In the short run it drives up the price level and increases real output;
in the long run, only price level rises. (See Figure 18.3)
B. Cost push inflation arises from factors that increase the cost of production at each price level;
the increase in the price of a key resource, for example. This shifts the short run supply to the
left, not as a response to a price level increase, but as its initiating cause. Cost-push inflation
creates a dilemma for policymakers. (See Figure 18.4)
18-3
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
1. If government attempts to maintain full employment when there is cost-push inflation an
inflationary spiral may occur.
2. If government takes a hands-off approach to cost push inflation, a recession will occur.
The recession may eventually undo the initial rise in per unit production costs, but in the
meantime unemployment and loss of real output will occur.
C. Recession and the extended AD-AS model.
1. When aggregate demand shifts leftward a recession occurs. If prices and wages are
downwardly flexible, the price level falls. The decline in the price level reduces nominal
wages, which then eventually shifts the aggregate supply curve to the right. The price
level declines and output returns to the full employment level. (See Figure 18.5)
2. This is the most controversial application of the extended AD-AS model. The key point
of dispute is how long it would take in the real world for the necessary price and wage
adjustments to take place to achieve the indicated outcome.
D. Economic Growth with Ongoing Inflation
1. The Aggregate demand-aggregate supply framework can also be used to illustrate growth,
as seen in Figure 18.6. As the Aggregate Supply schedule shifts outward this results in
economic growth.
2. However, in recent decades aggregate demand has shifted outward by an even greater
amount. Nominal GDP rises faster than real GDP. This also results in inflation, as shown
in figure 18.7.
IV. The Phillips Curve and the Inflation – Unemployment Tradeoff
A. Both low inflation and low unemployment are major goals. But are they compatible?
B. The Phillips Curve is named after A.W. Phillips, who developed his theory in Great Britain by
observing the British relationship between unemployment and wage inflation.
C. The basic idea is that given the short run aggregate supply curve, an increase in aggregate
demand will cause the price level to increase and real output to expand, and the reverse for a
decrease in AD. (Figure 18.9)
D. This tradeoff between output and inflation does not occur over long time periods.
E. Empirical work in the 1960s verified the inverse relationship between the unemployment rate
and the rate of inflation in the United States for 1961-1969. (See Figure 18.8b)
F. The stable Phillips Curve of the 1960s gave way to great instability of the curve in the 1970s
and 1980s. The obvious inverse relationship of 1961-1969 had become obscure and highly
questionable. (See Figure 18.10)
1. In the 1970s the economy experienced increasing inflation and rising unemployment:
stagflation.
2. At best, the data in Figure 18.10 suggest a less desirable combination of unemployment
and inflation. At worse, the data imply no predictable trade off between unemployment
and inflation.
18-4
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
G. Adverse aggregate supply shocks—the stagflation of the 1970s and early 1980s may have
been caused by a series of adverse aggregate supply shocks. (Rapid and significant increases
in resource costs.)
1. The most significant of these supply shocks was a quadrupling of oil prices by the
Organization of Petroleum Exporting Countries (OPEC).
2. Other factors included agricultural shortfalls, a greatly depreciated dollar, wage increases
and declining productivity.
3. Leftward shifts of the short run aggregate supply curve make a difference. The Phillips
Curve trade off is derived from shifting the aggregate demand curve along a stable short-
run aggregate supply curve. (See Figure 18.8)
4. The “Great Stagflation” of the 1970s made it clear that the Phillips Curve did not
represent a stable inflation/unemployment relationship.
H. Stagflation’s Demise.
1. Another look at Figure 18.10 reveals a generally inward movement of the
inflation/unemployment points between 1982 and 1989.
2. The recession of 1981-1982, largely caused by a tight money policy, reduced double-digit
inflation and raised the unemployment rate to 9.5% in 1982.
3. With so many workers unemployed, wage increases were smaller and in some cases
reduced wages were accepted.
4. Firms restrained their price increases to try to retain their relative shares of diminished
markets.
5. Foreign competition throughout this period held down wages and price hikes.
6. Deregulation of the airline and trucking industries also resulted in wage and price
reductions.
7. A significant decline in OPEC’s monopoly power produced a stunning fall in the price of
oil.
I. Global Perspective 18.1 portrays the “misery index” in 2001-2012 for several nations. The
index adds unemployment and inflation rates.
V. Long-Run Phillips Curve
A. This view is that the economy is generally stable at its natural rate of unemployment (or full-
employment rate of output).
1. The hypothesis questions the existence of a long-run inverse relationship between the rate
of unemployment and the rate of inflation.
2. Figure 18.11 explains how a short-run tradeoff exists, but not a long-run tradeoff.
3. In the short run we assume that people form their expectations of future inflation on the
basis of previous and present rates of inflation and only gradually change their
expectations and wage demands.
4. Fully anticipated inflation by labor in the nominal wage demands of workers generates a
vertical Phillips Curve. (See Figure 18.11) This occurs over time.
18-5
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
B. Interpretations of the Phillips Curve have changed dramatically over the past three decades.
1. The original idea of a stable tradeoff between inflation and unemployment has given way
to other views that focus more on long-run effects.
2. Most economists accept the idea of a short-run tradeoff—where the short run may last
several years—while recognizing that in the long run such a tradeoff is much less likely.
VI. Taxation and Aggregate Supply
A. Economic disturbances can be generated on the supply side, as well as on the demand side of
the economy. Certain government policies may reduce the growth of aggregate supply.
“Supply-side” economists advocate policies that promote output growth. They argue that:
1. The U.S. tax transfer system has negatively affected incentives to work, invest, innovate
and assume entrepreneurial risks.
a. To induce more work government should reduce marginal tax rates on earned
income.
b. Unemployment compensation and welfare programs have made job loss less of an
economic crisis for some people. Many transfer programs are structured to
discourage work.
2. The rewards for saving and investing have also been reduced by high marginal tax rates.
A critical determinant of investment spending is the expected after-tax return.
3. Lower marginal tax rates may encourage more people to enter the labor force and to work
longer. The lower rates should reduce periods of unemployment and raise capital
investment, which increases worker productivity. Aggregate supply will expand and keep
inflation low.
B. The Laffer Curve is an idea relating tax rates and tax revenues. It is named after economist
Arthur Laffer, who originated the theory. (See Figure 18.12)
1. As tax rates increase from zero, tax revenues increase from zero to some maximum level
(m) and then decline.
2. Tax rates above or below this maximum rate will cause a decrease in tax revenue.
3. Laffer argued that tax rates were above the optimal level and by lowering tax rates
government could increase the tax revenue collected.
4. The lower tax rates would trigger an expansion of real output and income enlarging the
tax base. The main impact would be on supply rather than aggregate demand.
5. Consider This … Sherwood Forest
Laffer likened the paying of taxes to passing through Sherwood Forest. To avoid Robin
Hood’s “taxation,” people avoided going through the forest whenever possible. If Robin
Hood had confiscated only a portion, his band’s revenue might have been higher as less
people would have avoided or evaded the forest (taxes).
C. Supply side economists offer two additional reasons for lowering the tax rate.
1. Tax avoidance (legal) and tax evasion (illegal) both decline when taxes are reduced.
2. Reduced transfers—tax cuts stimulate production and employment, reducing the need for
transfer payments such as welfare and unemployment compensation.
18-6
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
D. Criticisms of the Laffer Curve.
1. There is empirical evidence that the impact on incentives to work, save and invest is
small.
2. Tax cuts also increase demand, which can fuel inflation. Demand impacts may exceed
supply impacts.
3. The Laffer Curve (Figure 18.12) is based on a logical premise, but where the economy is
actually located on the curve is an empirical question and difficult to determine. It may
be hard to know in advance the impact of a tax cut on supply.
VII. LAST WORD: Do Tax Increases Reduce Real GDP?
A. Christina Romer and David Romer, two Economists at the University of California-Berkeley,
find evidence that suggests a tax increase will reduce real GDP.
B. By identifying the reason for the tax change, in conjunction with output movements, they
hope to identify a causal relationship between these tax changes and output movements.
C. Their results suggest that a tax increase of 1 percent of real GDP lowers real GDP by 2 to 3
percent. The evidence also suggests that these output deviations are relatively permanent.
D. However, it does appear that the intent of the tax increase matters. If the tax increase is to
reduce the deficit this tends to have a less negative effect on economic activity.
QUIZ
1. If government uses fiscal policy to restrain cost-push inflation, we can expect:
A. the unemployment rate to rise.
B. the unemployment rate to fall.
C. the aggregate demand curve to shift rightward.
D. tax-rate declines and increases in government spending.
2. An adverse aggregate supply shock:
A. automatically shifts the aggregate demand curve rightward.
B. causes the Phillips Curve to shift leftward and downward.
C. can be caused by a boost in the rate of growth of productivity.
D. can cause stagflation.
18-7
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
3. In the last half of the 1990s, the usual short-run tradeoff between inflation and unemployment did
not arise because:
A. the Fed held interest rates constant.
B. the Federal government balanced its budget.
C. the U.S. personal savings rate rose.
D. productivity (and thus aggregate supply) grew faster than previously.
4. The short run in macroeconomics is a period in which nominal wages:
A. Remain unresponsive as the price level stays constant
B. Change as the price level stays constant
C. Remain unresponsive as the price level changes
D. Change as the price level changes
5. If there is sufficient time for wage contracts to expire and nominal wage adjustments to occur,
then the:
A. Economy is operating in the short-run
B. Economy has entered the long-run
C. Unemployment rate will increase
D. Inflation rate will decrease
6. In the extended AD–AS model, demand-pull inflation occurs because of:
A. An increase in AD, resulting in a decrease in the short-run AS curve
B. An increase in nominal wages, resulting in an increase in the short-run AS curve
C. A decrease in nominal wages, resulting in a decrease in the short-run AS curve
D. An increase in nominal wages, resulting in a decrease in the short-run AS curve
18-8
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 18 – Extending the Analysis of Aggregate Supply
7. The traditional Phillips Curve shows the:
A. Direct relationship between the rate of inflation and the unemployment rate
B. Inverse relationship between the rate of inflation and the rate of unemployment
C. Direct relationship between the short-run and long-run aggregate supply
D. Inverse relationship between the short-run and long-run aggregate supply
8. In the long run, stability for the economy is achieved only at:
A. A high rate of profit
B. The natural rate of inflation
C. The natural rate of unemployment
D. The efficiency trade-off between unemployment and inflation
9. Which is a reason given by supply-side economists as to why tax cuts should increase aggregate
supply?
A. Saving will increase
B. Risk taking will decrease
C. Work incentives will decrease
D. The net export effect will increase
10. In an aggregate demand-aggregate supply framework, fiscal policy that emphasizes cutting taxes
as a means of improving incentives to work, save, and invest would be characterized as primarily
a shift
A. Rightward shift of the aggregate demand curve
B. Leftward shift of the aggregate demand curve
C. Rightward shift of the long-run aggregate supply curve
D. Leftward shift of the long-run aggregate supply curve
18-9
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.