Unit V (Extending the Analysis of AS)

• Short Run Aggregate Supply:

-Period in which wages and other input prices remains fixed as price level increase or decrease.

• Long Run Aggregate Supply:

-Period of time in which wages have become fully responsive to change in price level.

• Effects over short-run:

-In short run, price level changes allow for companies to exceed normal outputs and hire more workers because profits are increase 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 run AS curve is representative with a vertical line.

Demand pull inflation in the AS model.

Demand pull : prices increase based on the increase in AB

In Short run, demand pull will drive up prices and increase production.

In long run, increase in AB will eventually return to previous level. 

• Cost Push and the Extended Model:

cost-push arises from factors that will increase per unit cost 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 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 government could begin an inflationary spiral.

No action however could lead to recession by keeping production and employment levels declining. 

• The Long-Run Phillips Curve:

Natural rate of unemployment is held constant.

Because the Long Run Phillips curve exists at the natural rate of unemployment (UN) Structural changes in the economy that UN will also cause the Long-Run Phillips Curve to shift.

Increase in UN will shift Long-Run Phillips Curve right.

Decrease in UN will shift Long-Run Phillips Curve left.

• Short Run Phillips Curve:

Trade of between inflation and unemployment.

• Long Run Phillips Curve:

NO trade of between inflation and unemployment in the long run.

Occurs at natural rate of unemployment.

Represented by vertical line.

Long Run Phillips Curve will shift if the LRAS shifts.

Natural rate of unemployment is equal to frictional +structural + seasonal unemployment.

Maj LRPC assumption is that more worker benefits creates higher natural rates and fewer worker benefits creates lower natural rates. 

Supply Shock: Rapid and significant increase in resource cost, which causes SRAS curve to shift.

-Most likely shift to left and SRPC will shift right. 

Misery Intex: combo of inflation and unemployment in any given year.

Single digit misery is good. 

• Reaganomics/supply side economics 

Show change in AS not in AD, which determines the level of inflation, unemployment notes and economy growth.

Supply side economists, policies that promote GDP growth by arguing that high marginal tax votes along with the current system of transfer payments : Unemployment compensation welfare programs provide disincentive to work, invest, innovate and undertake entrepreneurial ventures. 

Low marginal tax rates induce more work, thus AS increase. 

-also makes leisure more expensive and work more attractive. 

• Incentives to save and invest: 

1) High marginal tax rates reduce the rewards for saving and investment.

2) Consumption might increase, but investments depend upon saving.

3) Lower marginal tax rates encourage savings and investing. 

• Laffer Curve:

Theoretical relationship between tax rates and government revenue. 

-As tax rates increase from (0) tax revenues increase from 0 to some max level and then declines. 

• Criticism of Laffer Curve:

Research suggests that the impact of the tax rates on incentives tow work, save, and invest are small.

Tax cuts increase demand, which can fuel inflation and demand may exceed supply.

Where the economy is actually located on the curve is difficult to determine.