Transcript Long Run Aggregate Supply

Long Run
Aggregate Supply
• While engaged in a lesson on longrun aggregate supply, you will
analyze the qualities of aggregate
supply in the long-run by
comparing it to aggregates supply
in the short-run.
We have looked at the AS/AD model
In detail. Now let’s extend that model
In order to distinguish between shortrun and long-run aggregate supply.
LRAS
SRAS
AD
Price Level
PL1 [3%]
0
E1
FE
Real GDP
In the long run aggregate supply is a Vertical line at full employment. The
Long-run aggregate supply curve is a vertical line because resource
prices eventually catch up
with production prices.
The short-run AS curve is
Up-sloping because higher
Price levels create
Incentives to expand
Output when recsource
Prices remain constant.
LRAS
SRAS
AD
PL1 [3%]
0
E1
FE
Real GDP
GROWTH IN THE AS/AD MODEL
This line is the same as the PPF curve. A right shift in the
LRAS line is the same as shifting the PPF to the right.
LRAS1 LRAS2
c
Price Level
Capital Goods
a
U
b
Consumer Goods
d
Y1
Y2
Real GDP
Factors that cause economic growth
1. Increase in resources -
c
2. Better resource quality -
LRAS1 LRAS2
3. Technological
advances -
U
b
Consumer Goods
But what is
the difference
d between
LRAS &
SRAS?
Price Level
Capital Goods
a
Y1
Y2
Real GDP
Short Run (SRAS)– a period in
which nominal wages (input cost)
remain fixed as PL (profits) increase
or decrease.
Long Run (LRAS)– a period in which
nominal wages are fully responsive to
PL changes.
Reasons why wages are fixed
in the SR
• Workers
may not immediately be aware that
inflation (increased PL) is eating up their real
wages (wealth) thus they may not demand
higher wages right away.
• Many
workers are hired under fixed-wage
contracts (Mr. Walton) and can not demand
higher wages until their contract expires.
Economic Growth &
Demand Pull Inflation
As LRAS shifts to the right it drags the AD curve
with it, thus an increase the PL.
LRAS1
LRAS2
Price Level
SRAS1
PL2
PL1
AD2
AD1
o
Y1 Y2
Real GDP
When PL is anticipated, equilibrium is the same for both the
SRAS curve & the LRAS curve at full employment.
LRAS
SRAS
AD
Price Level
PL1 [3%]
0
E1
FE
Real GDP
But when PL (inflation) is unanticipated, output
prices (profits) will increase, in the short run, while
input prices (cost/wages) LRAS
AS1
remain fixed.
AD1 AD2
6%
3%
More profits cause the law of
supply to kick in. Firms will
attempt to increase their
quantity supplied. They will offer
workers overtime, and entice
new workers into the labor force.
This will overextends the economy,
and cause demand-pull inflation.
E3
E2
E1
4%
Remember, an
Increase in quantity
Supply is shown as
Moving up a fixed AS
Curve.
3% Unemployment
In the long run, workers will discover that their real wages
have declined because of increased PL. They will demand
pay raises to restore the previous level of purchasing power
(real wages) that they enjoyed. LRASAS2 AS1
6%
3%
Since nominal wages are
one of the determinants of
AS, the SRAS curve will
shift leftward leaving higher
PL, but bringing the
economy back into
Equilibrium, as AD shifts
back to FE.
E3
E2
E1
ADlr
4%
3%
This is a naturally occurring trend in the market and
is the reason why PL continually increase from year
to year.
LRAS
SRAS
Price Level
Yr 3 [3%]
Yr 2 [3%]
Yr 1 [3%]
E1
AD
0
Y
Real domestic output
In the short run, demand-pull inflation drives up the price
level and increases real output. The initial increase in AD has
LRAS
moved the economy along the
up-ward sloping
AD2
Price Level
AS curve.
SRAS1
AD1
PL2[5%]
E2
E1
PL1[2%]
o
Y
1
Y2
Real domestic output
Price Level
For a while, the economy can operate beyond its FE level of
output. But the demand pull inflation will eventually cause
adjustment to nominal wages that LRAS
will return the
SRAS2
economy back
AD2
SRAS1
to its FE output.
AD1
PL2[5%]
PL1[2%]
o
E3
E2
E1
Y1 Y2
Real GDP
Cost-Push Inflation &
Stagflation
Cost-push inflation occurs when an increase in production
cost causes a shift in SRAS to the left. This causes an
increased PL, and widespread layoffs in the labor force.
Economic stagnation with inflation is called stagflation.
LRAS SRAS SRAS
AD
Price Level
1
PL2(10%)
2
E2
PL1[2%]
o
1
E1
Y2 Y1
10%
Real domestic output
If government attempts to fight unemployment by
increasing AD then inflation will spiral out of control.
Price Level
AD2 LRAS SRAS2
SRAS1
AD1
E3
PL3 [12%]
PL2 [10%]
E2
PL1[2%]
o
E1
Y2 Y1
10%
Real domestic output
But if government takes a hands-off approach
and allows a recession to occur, nominal
wages will fall and AS will return to its original
LRAS
location.
AD1
SRAS1 SRAS
Price Level
2
PL2[10%]
PL1[2%]
o
E2
E2
E1
Y2 Y1
10%
Real domestic output
If the Federal Reserve tightens the money supply,
the recession will worsen. But the lack of currency
will cause its value to increase, leading to PL
declining.
LRAS
Price Level
AD1
PL2[10%]
PL1[2%]
o
SRAS1 SRAS2
E2
E1
Y2 Y1
10%
Real domestic output
A Word From Arnold
Learn economics.
Don’t be “economic
girlie men.”