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Chapter 16: Extending the Analysis of Aggregate Supply

The purpose of this chapter includes the following:1. Extend the AD-AS model to include short run and long

run2. Apply the AD-AS model to the following:

a. Demand-pull Inflationb. Cost-push Inflationc. Recession

3. Examine the relations between inflation and unemployment (SR & LR Phillips Curve)

4. State and evaluate the tenets of supply-side economics. (Incentives of tax structure for: Work, Saving, Investment)

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From Short-Run to Long-Run Aggregate Supply

1. Short Run is a period in which nominal wages (and other input prices) remain fixed as the price level changes.a. Workers are not immediately aware of how inflation has affected their nominal wages.b. Wage contracts may not allow workers to take immediate action to increase their nominal wages even though they have recognized that inflation has reduced the purchasing power of their nominal wages.

2. Long run is a period in which nominal wages are fully responsive to changes in the price level.

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Short-Run Aggregate Supply (See Figure 16-1a)

1. Use the AS curve as shown in Figure 16-1a.

2. Assumptions:

a. The initial price level is P1.

b. The nominal wages have been established on the expectation that this specific price level will continue.

c. The price level is flexible both upward and downward.

Conclusion: The SR AS curve is up-sloping.

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Long-Run Aggregate Supply (See Figure 16-1b)

Conclusion: The LR AS curve is vertical at the natural rate of unemployment.

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Equilibrium in the Extended AD-AS Model (See Figure 16-2)

Conclusion: LR equilibrium has the price level at P1 and the real output at the level of Qf.

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Demand-Pull Inflation in the Extended AD-AS Model (Figure 16-3)

Conclusions:

1. In the short run, demand-pull inflation drives up prices and increases real output.

2. In the long run, demand-pull inflation drives up prices, but has no output effect.

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Cost-Push Inflation in the Extended AD-AS Model (Figure 16-4)

Conclusion: If government takes action to reduce unemployment, then more inflation is the result. If government lets the recession occur, then the AS eventually moves back to the right and full employment is restored. (Nominal wages fall.)

Two Generalizations:

1. If government attempts to maintain full employment when cost-push inflation occurs, then an inflationary spiral may be set off.

2. If government takes no action regarding the recession, then the economy will suffer high unemployment and the loss of real output.

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Recession and the Extended AD-AS Model (Figure 16-5)

Conclusion: The economy may solve the problem of recession on its own, but how much time will it take.

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The Phillips Curve

1. Idea proposed by A. W. Phillips, a British economist2. It suggests a tradeoff between the rates of inflation and

unemployment, i.e., society had to choose between the incompatible goals of price stability and full employment.

See Figure 16-6 for the derivation. Compare inflation rates to unemployment rates for moves of AD, given AS.AD0 to AD1 small inflation, but high unemployment.AD0 to AD2 more inflation, but less unemployment.AD0 to AD3 more inflation, but less unemployment.

See Figure 16-7 for the theoretical and empirical Phillips Curve. (Data for the US economy during the 1960s.)

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Q: What happened to the Phillips Curve from 1961 to 1997?A: A series of aggregate supply shocks either moved the curve upward and to

the right or suggested that it was very unstable.

A series of supply shocks hit the US economy during the 1970s from OPEC causing cost of production to rise significantly. (See Figure 16-8)

1. In 1970s OPEC quadrupled oil prices, which affected production costs in almost every industry in the US.a. From 1973 to 1975 unemployment went from 4.8% to 8.3% and prices rose by 21%.b. From 1978 to 1980 unemployment went from 6.0% to 7.5% and prices rose by 26%.

2. During the period of the late 1980s and the early 1990s stagflation declined and the Phillips Curve moved back toward the 1960 levels.

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Long-Run Phillips Curve

1. This is no apparent long-run tradeoff between inflation and unemployment.

2. Use Figure 16-9, pp. 315-316 to explain the vertical long-run Phillips Curve.

a. Short-Run Phillips Curve

b. Long-Run Phillips Curve

c. Disinflation explains the movement down the LR Phillips Curve.

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Taxation and Aggregate Supply

1. Government policies can either discourage or encourage rightward shifts of the short-run and long-run AS curves; see Figure 16.2.

2. Supply-siders focus their attention on marginal tax rates; see Table 5.1 for a 2003 example of marginal tax rates.

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Taxation and Aggregate Supply, cont.

3. Government policies of high taxes have impeded productivity growth and slowed the long-term expansion of AS. High taxes rates have reduced the benefits of working, saving and investing.

4. Taxes and Incentive to Worka. Lower taxes would increase the incentive to work by placing a higher opportunity cost on

leisure.b. Lower taxes would increase productive effort in several ways: increase the number of

hours worked per unit of time; encourage workers to postpone retirement; induce more people to enter the labor force; motivate people to work harder and to avoid long periods of unemployment.

5. Taxes and Incentives to Save and Investa. Lower taxes would increase the rewards for saving.b. Example: Saving $10,000 at 6% interest would yield $600 of interest. If the marginal tax

rate is 30%, then the after-tax interest earnings would be $420, i.e., an after-tax interest rate of 4.2%. With a tax rate of 20%, then the after-tax interest earnings would be $480, i.e., an after-tax interest rate of 4.8%. Higher after-tax interest rates would better encourage one to save and not consume.

c. Saving allows a pool of funds that are available for investment.d. Lower taxes on earnings from capital investments increases the after-tax returns on

investment and encourages firms to invest in new capital with superior technologies.e. Lower marginal tax rates increase labor productivity, expand the long-run AS and

economic growth, which keeps unemployment and inflation low.

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The Laffer Curve, Figure 16-10 summarizes the issue of taxation and incentives to earn income.

1. Point m on the curve suggests a tax rate that produces maximum tax revenue.

2. In the early 1980s Arthur Laffer argued that the US was at a point such as n on the curve.

a. Lowering tax rates would either increase tax revenues or leave them unchanged.

b. Lowering the tax rate from point n to point l would stimulate production and raise the same amount of tax revenue.

c. Further, lowering tax rates would reduce tax avoidance and tax evasion. (Benefit vs. Cost)

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Criticisms of The Laffer Curve

1. Skeptics claim that empirical evidence shows that the impact of tax cuts on incentives is small, of uncertain direction and slow to develop.

a. Some people work more and some people work less with lower tax rates.

b. Those who work more are encouraged by the higher opportunity cost of leisure.

c. Those who work less can earn the same level of after-tax income by working fewer hours than before.

2. Inflation or Higher Real Interest Rates

a. Most economists think that the demand-side effects of a tax cut are much stronger than the supply-side effects.

b. Tax cuts that are imposed at or near full employment are likely to bring about inflation, tight money policy and reductions in investment.

3. Position on the Curve (This is an empirical question.)a. If we are at a point such as n, then a tax cut will increase tax revenue.

b. If we are at a point such as m, then a tax cut will decrease tax revenue.

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Rebuttal and Evaluation of The Laffer Curve

1. In the 1980s taxes were cut by reducing the upper marginal rate of taxation from 50% to 28% and real GDP and tax revenues were substantially higher at the end of the 1980s than at the beginning.

a. Supply-siders argued that things had worked as Laffer predicted.

b. Most economists believed that the Reagan tax cuts made during a severe recession, helped increase AD and returned GDP to full employment level and a normal growth path. (The Laffer Curve shifted to the right, increasing net tax revenues.) Saving fell as a % of personal income; productivity growth was sluggish; and real GDP growth was not real strong. Government spending rose more rapidly than tax revenues in the 1980s and large deficits resulted.

2. In 1993, the Clinton administration increased the top marginal tax rates from 31% to 39.6% to reduce the deficits of the 1980s. The economy boomed in the last half of the 1990s and the budget was in surplus for 1998, 1999, 2000, 2001.

3. In 2001, the Bush administration reduced tax rates over a series of years “to return excess revenues to taxpayers.” In 2003 the top marginal tax rate fell to 35%.

4. Today, there is general agreement that the US economy is operating at a point below m on the Laffer Curve. Changes in marginal tax rates do alter taxpayer behavior, if only modestly and must be considered in designing tax policy.

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Suggestions:

Work problems pps. 306-307: 3., 4., 6., 8.

Work through M-C questions in study guide.

Take two quizzes for chapter from the McConnell website.