Extending the Analysis of Aggregate Supply

The basic AD-AS model treats the short run and long run as distinct, but the relationship between them deserves closer attention. This chapter extends the supply side of the model: it sharpens the distinction between short-run and long-run aggregate supply, develops the Phillips curve and the trade-off between inflation and unemployment, and explains the puzzle of stagflation.

Short-Run Versus Long-Run Aggregate Supply

The key difference between the two horizons is the behavior of input prices, especially wages.

In the short run, many wages and other input prices are fixed by contracts and slow to adjust. As a result, a rise in the price level increases firms' profit margins and induces them to expand output, giving the short-run aggregate supply curve its upward slope.

In the long run, all prices and wages fully adjust. Once workers and firms have renegotiated wages to reflect the new price level, the temporary profit incentive disappears and output returns to its potential, full-employment level. The long-run aggregate supply curve is therefore vertical at potential output: in the long run, the economy's output is set by real resources and technology, not by the price level.

The Phillips Curve

The Phillips curve describes a short-run inverse relationship between inflation and unemployment. When aggregate demand is strong, unemployment falls but inflation rises; when demand is weak, unemployment rises but inflation falls. This suggested, for a time, that policymakers could choose a permanent trade-off — accepting somewhat higher inflation in exchange for lower unemployment.

Inflationary Expectations and the Long Run

Experience in the 1970s overturned the idea of a stable, exploitable trade-off. The reason is inflationary expectations. If policymakers repeatedly stimulate demand to hold unemployment low, people come to expect higher inflation and build it into wage and price decisions. The short-run Phillips curve then shifts upward, leaving the economy with the same unemployment but higher inflation.

This led to the modern view: there is a meaningful inflation-unemployment trade-off in the short run, but no permanent trade-off in the long run. In the long run unemployment returns to its natural rate regardless of the inflation rate, so the long-run Phillips curve is vertical — mirroring the vertical long-run aggregate supply curve.

Stagflation and Supply Shocks

The model also explains stagflation — the simultaneous occurrence of stagnant output (high unemployment) and rising prices (inflation) — which the simple demand-driven story cannot. The culprit is an adverse supply shock, such as the oil price spikes of the 1970s. By raising production costs, a supply shock shifts the short-run aggregate supply curve to the left, pushing prices up and output down at the same time.

Stagflation is a policymaker's dilemma. Fighting the inflation with tighter policy deepens the unemployment, while fighting the unemployment with looser policy worsens the inflation. There is no easy remedy, which is precisely why supply shocks are so disruptive.

The Supply Side

These ideas underpin supply-side perspectives on policy, which emphasize measures that shift aggregate supply rightward — improving productivity, lowering production costs, and strengthening incentives to work and invest. Whatever one's view of specific supply-side prescriptions, the broader lesson is durable: lasting improvements in output and living standards come from expanding the economy's productive capacity, not merely from managing demand.

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Next chapter: we open the economy to the rest of the world, beginning with the theory and gains from international trade.

Further Listening & Reading

• 🎧 Planet Money: How Bill Phillips Used Flowing Water to Model the Economy (NPR) — the story behind the Phillips curve.