long run long run aggregate supply. while engaged in a lesson on long- run aggregate supply, you...
TRANSCRIPT
Long Run Long Run Aggregate SupplyAggregate Supply
• While engaged in a lesson on long-run aggregate supply, you will analyze the qualities of aggregate supply in the long-run by comparing it to aggregates supply in the short-run.
0
PLPL1 [3%]1 [3%]
SRASSRAS
EE11
FEFE
Price LevelPrice Level
Real GDPReal GDP
ADAD
LRASLRASWe have looked at the AS/AD model We have looked at the AS/AD model In detail. Now let’s extend that modelIn detail. Now let’s extend that modelIn order to distinguish between short-In order to distinguish between short-run and long-run aggregate supply.run and long-run aggregate supply.
0
PLPL1 [3%]1 [3%]
SRASSRAS
EE11
FEFE Real GDPReal GDP
ADAD
LRASLRAS
In the In the long run aggregate supply is a Vertical line at full employment. The long run aggregate supply is a Vertical line at full employment. The Long-run aggregate supply curve is a vertical line because resourceLong-run aggregate supply curve is a vertical line because resourceprices eventually catch upprices eventually catch upwith production prices.with production prices.The short-run AS curve isThe short-run AS curve isUp-sloping because higherUp-sloping because higherPrice levels create Price levels create Incentives to expand Incentives to expand Output when recsourceOutput when recsourcePrices remain constant.Prices remain constant.
GROWTH IN THE AS/AD MODELGROWTH IN THE AS/AD MODELC
ap
ital G
ood
s
Consumer GoodsP
rice L
evel
Real GDP
LRAS1LRAS1 LRAS2LRAS2
YY11 YY22
UU
aa
bb
cc
dd
This line is the same as the PPF curve. A right shift in theLRAS line is the same as shifting the PPF to the right.
Factors that cause economic growthFactors that cause economic growthC
ap
ital G
ood
s
Consumer GoodsP
rice L
evel
Real GDP
LRAS1LRAS1 LRAS2LRAS2
YY11 YY22
1. Increase in resources -
2. 2. Better resource qualityBetter resource quality - -
3. 3. TechnologicalTechnological advancesadvances - -
UU
aa
bb
cc
dd
But what is the difference between LRAS & SRAS?
SShort hort RRun (SRAS)un (SRAS)– a period in which nominal wages (input cost) remain fixed as PL (profits) increase or decrease.
LLongong RRun (LRAS)– a period in which un (LRAS)– a period in which nominal wages are fully responsive to nominal wages are fully responsive to PL changesPL changes..
• 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.
Reasons why wages are fixed Reasons why wages are fixed in the SRin the SR
• 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
Pri
ce L
evel
Real GDP
o
PL1
LRASLRAS11
AD2
Y1
LRASLRAS22
Y2
AD1
SRASSRAS11
PL2
As LRAS shifts to the right it drags the AD curve with it, thus an increase the PL.
0
PLPL1 [3%]1 [3%]
SRASSRAS
EE11
FEFE
Price LevelPrice Level
Real GDPReal GDP
ADAD
LRASLRAS
WhenWhen PL is anticipated, equilibrium is the same for both the PL is anticipated, equilibrium is the same for both the SRAS curve & the LRAS curve at full employmentSRAS curve & the LRAS curve at full employment..
66%%
33%%
44%%
ASAS11
ADAD11
EE11
EE22EE33
LRASLRAS
33%%
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.
ADAD22
But when PL (inflation) is unanticipated, output prices (profits) will increase, in the short run, while input prices (cost/wages) remain fixed.
Unemployment
Remember, an Increase in quantitySupply is shown as Moving up a fixed AS Curve.
66%%
33%%
44%%
ASAS11ASAS22
EE11
EE22EE33
LRASLRAS
33%%
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.
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.
ADlr
0
Yr 1Yr 1 [3%] [3%] EE11
YY
Pri
ce L
evel
Pri
ce L
evel
Real domestic outputReal domestic output
ADAD
LRASLRAS
This is a naturally occurring trend in the market and This is a naturally occurring trend in the market and is the reason why PL continually increase from year is the reason why PL continually increase from year to yearto year. .
Yr 2Yr 2 [3%] [3%]
Yr 3Yr 3 [3%] [3%]
SRASSRAS
o
PLPL1[1[22%]%]
SRASSRAS11
LRASLRAS
ADAD11
EE11
YY11
Pri
ce L
evel
Pri
ce L
evel
Real domestic outputReal domestic output
EE22PLPL2[2[55%]%]
ADAD22
YY22
In the short run, demand-pull inflation drives up the price level and increases real output. The initial increase in AD has moved the economy along the
up-ward sloping
AS curve.
o
PLPL1[1[22%%]]
SRASSRAS11
LRASLRAS
ADAD11
EE11
YY11
Pri
ce L
evel
Pri
ce L
evel
Real GDPReal GDP
EE22PLPL2[2[55%%]]
ADAD22
SRASSRAS22
EE33
YY22
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 will return the economy back to its FE output.
Cost-Push Inflation & Stagflation
YY22
1010%%
oo
PLPL1[2%]1[2%] E1
YY11
Pri
ce
Lev
el
Pri
ce
Lev
el
Real domestic outputReal domestic output
EE22PLPL22(10(10%%))
Cost-push inflation occurs when an increase in production Cost-push inflation occurs when an increase in production cost causes a shift in SRAS to the leftcost causes a shift in SRAS to the left. . This causes an This causes an increased PL, and widespread layoffs in the labor forceincreased PL, and widespread layoffs in the labor force. . Economic stagnation with inflation is called stagflationEconomic stagnation with inflation is called stagflation..
SRASSRAS22LRASLRASADAD11 SRASSRAS11
YY22oo
PLPL11[2%][2%] EE11
YY11
Pri
ce L
evel
Pri
ce L
evel
Real domestic outputReal domestic output
EE22 PLPL2 [10%]2 [10%]
PLPL3 [12%]3 [12%]
If government attempts to fight unemployment by increasing AD then inflation will spiral out of control.
EE33
10%10%
LRASLRASADAD22SRASSRAS22
SRASSRAS11ADAD11
YY22oo
PLPL11[22%%] EE11
YY11
Pri
ceP
rice
Lev
el
Real domestic outputReal domestic output
EE22PLPL22[1010%%]
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 location.
1010%%
SRASSRAS11ADAD11 SRASSRAS22
LRASLRAS
EE22
YY22oo
PLPL11[22%%] EE11
YY11
Pri
ceP
rice
Lev
el
Real domestic outputReal domestic output
EE22PLPL22[1010%%]
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.
1010%%
SRASSRAS11ADAD11 SRASSRAS22
LRASLRAS
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