Unit 5 and 6

Short Run Aggregate Supply

Short Run Aggregate demand

• Period in which wages ( and other input prices) remain fixed as price level increases or decreases

Effects over short run

• Price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant
• In long run, wages will adjust to price level and previous output levels will adjust accordingly

Equilibrium in the extended model

• Inclusion of both short run and long run aggregate supply
• long run curve is representative of natural rate of unemployment

Demand Pull Inflation in AS model

• Demand Pull Prices - Prices increase based on increase in aggregate demand
• Short run- demand pull will drive prices up and increase production
• Long run- increases in aggregate demand will eventually return to previous levels
• Demand Pull Inflation

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
• Cost Push Inflation
• Cost Push Inflation video

Dilemma for 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 eployment levels declining.

The Phillips Curve

• Because Long Run Philips Curve (LRPC) exists at the natural rate of unemployment (Un) structural changes in the economy that affect Un will also cause the LRPC to shift
• Increases in Un will shift LRPC to right
• Decrease in Un will shift LRPC to left

                                                                 Relation to AS/AD

changes in AS/AD model can also be seen on the Philips curve   *MIRROR IMAGES*

• LRPC occurs at natial rate of unemployment
• Always represented by a yellow line
• There is no tradeoff between unemployment and inflation
• LRPC will only shift if LRAS shifts
• If Natural Rate of Unemployement (NRU) changes, so does LRPC
• NRU = frictional + structural + seasonal unemployment (4% to 5%)

Major LRPC assumpltion is that more workers benefits create higher natural rates and a few workers benefits create lower natural rates

Misery Index

• Combinstion of Inflation and Unemployment in any given year

*Single digit money is good*

ex : inflation 2% and unemployment 4% economy is relatively good

Supply Shocks

• Rapid and significant increase in resource cost

              *caused by war, weather, tax, etc*

supply shocks

supply shocks and disinflation

Supply Side Economics

• Changes in AS and AD are the main active force in determining the level of unemployment rates, inflation, and economic growth.
• supply side economics

Supply Side Economist

• Support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payments such as unemployment compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures

Incentives to Save and Invest

1. High Marginal Tax Rates

         - Reduce the incentive for savings and investments

     2.   Consumption

         - Might increase but investments depend upon saving

     3.    Lower Marginal Tax Rates

         - Encourage saving and investment

Laffer Curve

• Theoretical relationship between tax rates and tax revenues
• As tax rates increase from zero, tax revenue increases from zero to some max levels and then declines
• Laffer Curve Explained

3 conditions of Laffer Curve

1. Evidence suggests that the impact of tax rates on incentives to work, save, and invest are small
2. Tax cuts also increase demand which can fuel inflation and demand may exceed supply
3. Where the economy is actually located on the curve is difficult to determine