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SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY Short Run Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Long Run - CHAPTER 33 Period in which nominal wages are fully responsive to previous changes in the price level 1 AGGREGATE DEMAND AND AGGREGATE SUPPLY SHORT-RUN AGGREGATE SUPPLY A higher price level increases profits and output moving the economy from a1 to a2 AS1 Price Level P2 P1 o CHAPTER 33 a2 a1 Q1 Q2 Real domestic output AGGREGATE DEMAND AND AGGREGATE SUPPLY 2 SHORT-RUN AGGREGATE SUPPLY A lower price level decreases profits and output moving the economy from a1 to a3 AS1 Price Level P2 P1 P3 o CHAPTER 33 a2 a1 a3 Q3 Q1 Q2 Real domestic output AGGREGATE DEMAND AND AGGREGATE SUPPLY 3 LONG RUN AGGREGATE SUPPLY A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left ASLR AS2 Price Level P2 P1 o CHAPTER 33 b1 AS1 a2 a1 Q1 Q2 Real domestic output AGGREGATE DEMAND AND AGGREGATE SUPPLY 4 LONG RUN AGGREGATE SUPPLY A lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right ASLR AS2 b1 Price Level P2 AS3 a1 P1 P3 o CHAPTER 33 AS1 a2 a3 Q3 c1 Q1 Q2 Real domestic output AGGREGATE DEMAND AND AGGREGATE SUPPLY 5 Why the LRAS Curve Might Shift Any event that changes any of the determinants of YN will shift LRAS. P LRAS1 LRAS2 Example: Immigration increases L, causing YN to rise. YN CHAPTER 33 Y’ N AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 6 Using AD & AS to Depict LR Growth and Inflation Over the long run, tech. progress shifts LRAS to the right and growth in the money supply shifts AD to the right. Result: ongoing inflation and growth in output. CHAPTER 33 P LRAS2000 LRAS1990 LRAS1980 P2000 P1990 AD2000 P1980 AD1990 AD1980 Y1980 Y1990 Y2000 AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 7 Economic Fluctuations Caused by events that shift the AD and/or AS curves. Four steps to analyzing economic fluctuations: 1. Determine whether the event shifts AD or AS. 2. Determine whether curve shifts left or right. 3. Use AD-AS diagram to see how the shift changes Y and P in the short run. 4. Use AD-AS diagram to see how economy moves from new SR eq’m to new LR eq’m. CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 8 Two Big AD Shifts: 1. The Great Depression U.S. Real GDP, billions of 2000 dollars From 1929-1933, CHAPTER 33 700 650 600 550 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1934 u-rate rose from 3% to 25% 750 1933 P fell 22% 800 1932 Y fell 27% 850 1931 • • • stock prices fell 90%, reducing C and I 900 1930 • money supply fell 28% due to problems in banking system 1929 • 9 Two Big AD Shifts: 2. The World War II Boom 2,000 Y rose 90% 1,400 P rose 20% 1,200 unemp fell from 17% to 1% 1,000 1,800 1,600 CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1944 1943 1942 800 1939 • • • govt outlays rose from $9.1 billion to $91.3 billion 1941 • U.S. Real GDP, billions of 2000 dollars 1940 From 1939-1944, 10 The Effects of a Shift in AD Event: stock market crash P 1. affects C, AD curve LRAS 2. C falls, so AD shifts left 3. SR eq’m at B. P and Y lower, unemp higher 4. Over time, PE falls, SRAS shifts right, until LR eq’m at C. Y and unemp back at initial levels. CHAPTER 33 SRAS1 A P1 P2 SRAS2 B P3 AD1 C AD2 Y2 YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 11 ACTIVE LEARNING Exercise 2: Draw the AD-SRAS-LRAS diagram for the U.S. economy, starting in a long-run equilibrium. A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. 12 ACTIVE LEARNING Answers 2: Event: boom in Canada P 1. affects NX, AD curve LRAS SRAS2 2. shifts AD right 3. SR eq’m at point B. P and Y higher, unemp lower P3 4. Over time, PE rises, SRAS shifts left, until LR eq’m at C. Y and unemp back at initial levels. P1 C SRAS1 B P2 A AD2 AD1 YN Y2 Y 13 The Effects of a Shift in SRAS Event: oil prices rise 1. increases costs, P shifts SRAS (assume LRAS constant) 2. SRAS shifts left 3. SR eq’m at point B. P2 P higher, Y lower, unemp higher P1 From A to B, stagflation, a period of falling output and rising prices. CHAPTER 33 LRAS SRAS2 SRAS1 B A AD1 Y2 YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 14 Accommodating an Adverse Shift in SRAS If policymakers do nothing, 4. Low employment causes wages to fall, SRAS shifts right, until LR eq’m at A. Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to YN, but P permanently higher. CHAPTER 33 P LRAS SRAS2 P3 P2 P1 C B A SRAS1 AD2 AD1 Y2 YN AGGREGATE DEMAND AND AGGREGATE SUPPLY Y 15