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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