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Aggregate Supply in the Short and Long Run Aggregate Supply • Aggregate supply measures total production within our economy – It is determined by current price levels and three factors of production • Input prices, productivity levels (input vs output) and legal-institutional factors (taxes and government regulations) AGGREGATE SUPPLY IN THE SHORT AND LONG-RUN Short Run Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Long Run Period in which nominal wages are fully responsive to previous changes in the price level 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 a2 a1 Q1 Q2 Real domestic output SHORT-RUN AGGREGATE SUPPLY A lower price level decreases profits and output moving the economy from a1 to a3 AS1 Price Level P2 a2 P1 P3 o a1 a3 Q3 Q1 Q2 Real domestic output SHORT RUN AGGREGATE SUPPLY • There are three reasons why the Short run Aggregate Supply curve is upward sloping. • Sticky wages - as prices rise wages may be slow to follow, allowing business owners to profit from higher prices. • Sticky prices- all prices do not rise simultaneously. A business that is slow to raise their prices may sell more in the short run. • Misperceptions of price increases – a business owner may assume incorrectly that the increase in price level is the result of an increase in demand for THEIR product and therefore increase production. Why the Short-run Aggregate Supply Curve Might Shift Shifts arising from a change in Labor costs. Shifts arising from a change in Capital costs. Shifts arising from a change in Natural Resource costs. Shifts arising from a change in Technology. Shifts arising from a change in the Expected Price Level. Shifts Arising from a Change in Expected Price Level When people expect an increase in price levels they tend to set wages high. This shifts the short-run aggregate supply curve to the left. When people expect a decrease in price levels the tend to set wages low. This shifts the short-run aggregate supply curve to the right. The Aggregate Supply Curve In the short run, the aggregate-supply curve is upward sloping. In the long run, the aggregate-supply curve is vertical. The long-run curve is derived from the shifts of the short-run curve that happen in the long-run. The long-run is the period of time when wages (and other input costs) catch up with prices. LONG RUN AGGREGATE SUPPLY A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left. The result is higher prices, but a return to the original level of output. AS2 Price Level P2 P1 o b1 AS1 a2 a1 Q1 Q2 Real domestic output LONG RUN AGGREGATE SUPPLY A lower price level reduces nominal wages and shifts the short-run aggregate supply to the right. This results in lower prices, but a return to the original level of output. ASLR b1 Price Level P2 AS2 AS1 a2 AS3 a1 P1 P3 o a3 Q3 c1 Q1 Q2 Real domestic output The Long Run Aggregate Supply Curve • The Long run AS curve represents the economy at its full employment/natural rate of unemployment level. • It is the level of output that an economy can produce if all of its resources are fully employed. • An equilibrium point to the left of the LRAS indicates we are below full employment. An equilibrium point to the right of the LRAS indicates that we are beyond full employment. The Long-Run Aggregate- Supply Curve... Price Level P1 Long-run aggregate supply 2. …does not affect the quantity of goods and services supplied in the long run. P2 1. A change in the price level… 0 Natural rate of output Quantity of Output The Long-Run Aggregate Supply Curve In the long-run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The price level does not affect these variables in the long run.