Chapter 16 - Extending the Analysis of Aggregate Supply
Introduction
Recent focus on the long-run adjustments and economic outcomes has renewed debates about stabilization
policy and causes of instability.
This chapter makes the distinction between short run and long run aggregate supply.
The extended model is then used to glean new insights on demand-pull and cost-push inflation.
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.
Short-Run and Long-Run Aggregate Supply
Definition:Short-run and long-run.
For macroeconomics the short-run is a period in which nominal wages (and other input prices) remain fixed
as the price level changes.
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.
Employees hired under fixed wage contracts must wait to renegotiate regardless of changes in the
price level.
Long run aggregate supply (See Figure 16-1b). Formed by long-run equilibrium points a1, b1, c1.
In the long run, nominal wages are fully responsive to price level changes.
The long run aggregate supply curve is a vertical line at the full employment level of real GDP. (See
Figure 16-1b) (b1, a1, c1).
Short-run aggregate supply curve AS1, is constructed with three assumptions. (see Figure 16-1a)
The initial price level is given at P1.
Nominal wages have been established on the expectation that this specific price level will persist.
The price level is flexible both upward and downward.
If the price level rises, higher product prices with constant wages will bring higher profits and increased
output.(See Figure 16-1a)(The economy moves from a1 to a2 on curve AS1.)
If the price level falls, lower product price with constant wages will bring lower profits and decreased output.
(See Figure 16-1a)(The economy moves from a1 to a3 on curve AS1.)
The extended AD-AS makes the distinction between the short run and long run aggregate supply curves.(See
Figure 16-2)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.
Applying the Extended AD-AS Model
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 16-3)
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 16-4)
If government attempts to maintain full employment when there is cost-push inflation an inflationary spiral
may occur.
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.
Recession and the extended AD-AS model.
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 16-5)
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.
The Phillips Curve and the Inflation - Unemployment Tradeoff
Both low inflation and low unemployment are major goals.But are they compatible?
Introduction
Recent focus on the long-run adjustments and economic outcomes has renewed debates about stabilization
policy and causes of instability.
This chapter makes the distinction between short run and long run aggregate supply.
The extended model is then used to glean new insights on demand-pull and cost-push inflation.
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.
Short-Run and Long-Run Aggregate Supply
Definition:Short-run and long-run.
For macroeconomics the short-run is a period in which nominal wages (and other input prices) remain fixed
as the price level changes.
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.
Employees hired under fixed wage contracts must wait to renegotiate regardless of changes in the
price level.
Long run aggregate supply (See Figure 16-1b). Formed by long-run equilibrium points a1, b1, c1.
In the long run, nominal wages are fully responsive to price level changes.
The long run aggregate supply curve is a vertical line at the full employment level of real GDP. (See
Figure 16-1b) (b1, a1, c1).
Short-run aggregate supply curve AS1, is constructed with three assumptions. (see Figure 16-1a)
The initial price level is given at P1.
Nominal wages have been established on the expectation that this specific price level will persist.
The price level is flexible both upward and downward.
If the price level rises, higher product prices with constant wages will bring higher profits and increased
output.(See Figure 16-1a)(The economy moves from a1 to a2 on curve AS1.)
If the price level falls, lower product price with constant wages will bring lower profits and decreased output.
(See Figure 16-1a)(The economy moves from a1 to a3 on curve AS1.)
The extended AD-AS makes the distinction between the short run and long run aggregate supply curves.(See
Figure 16-2)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.
Applying the Extended AD-AS Model
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 16-3)
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 16-4)
If government attempts to maintain full employment when there is cost-push inflation an inflationary spiral
may occur.
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.
Recession and the extended AD-AS model.
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 16-5)
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.
The Phillips Curve and the Inflation - Unemployment Tradeoff
Both low inflation and low unemployment are major goals.But are they compatible?
