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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.”