Chapter 38 _ Extending the Analysis of Aggregate Supply _ ECON 2020.pdf - \u201cOur goals in this chapter are to extend the analysis of aggregate supply to

Chapter 38 _ Extending the Analysis of Aggregate Supply _ ECON 2020.pdf

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“Our goals in this chapter are to extend the analysis of aggregate supply to the long run, examine the inflation-unemployment relationship, and evaluate the effect of taxes on aggregate supply. The latter is a key concern of so-called supply-side economics.” 38.1 [From Short Run to Long Run]: Explain the relationship between short-run aggregate supply and long-run aggregate supply. FIGURE 38.1 Short-run and long-run aggregate supply. (a) In the short run, nominal wages and other input prices do not respond to price-level changes and are based on the expectation that price level P1 will continue. An increase in the price level from P1 to P2 increases profits and output, moving the economy from a1 to a2; a decrease in the price level from P1 to P3 reduces profits and real output, moving the economy from a1 to a3. The short-run aggregate supply curve therefore slopes upward. (b) In the long run, a rise in the price level results in higher nominal wages and other input prices and thus shifts the short-run aggregate supply curve to the left. Conversely, a decrease in the price level reduces nominal wages and shifts the short-run aggregate supply curve to the right. After such adjustments, the economy obtains equilibrium of points such as b1 and c1. Thus, the long-run aggregate supply curve is vertical at the full-employment output. In the short run, firms can’t account for wage changes so instead they lay off workers, in the long-run firms can account for wage changes. _____________________________________________________________________________________ 38.2 [Applying the Extended AD-AS Model]: Explain how to apply the “extended” (short-run/long-run) AD-AS model to inflation, recessions, and economic growth. But now the distinction between short-run aggregate supply and long-run aggregate supply becomes important. With the economy producing above potential output, inputs will be in high demand. Input prices including nominal wages will rise. As they do, the short-run aggregate supply curve will ultimately shift leftward such that it intersects long-run aggregate supply at point c. There, the economy has reestablished long-run equilibrium, with the price level and real output now P3 and Qf, respectively. Only at point c does the new aggregate demand curve AD2 intersect both the short-run aggregate supply curve AS2 and the long-run aggregate supply curve ASLR. In the short run, demand-pull inflation drives up the price level and increases real output; in the long run, only the price level rises.
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Government can counter this recession, negative GDP gap, and attendant high unemployment by using fiscal policy and monetary policy to increase aggregate demand to AD2. But there is a potential policy trap here: An increase in aggregate demand to AD2 will further raise inflation by increasing the price level from P2 to P3 (a move from point b to point c).
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