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Module Aggregate Supply: Introduction and Determinants 18

What you will learn in this Module : How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy What factors can shift the aggregate supply curve Why the aggregate supply curve is different in the short run from in the long run

The relationship between the price level and the real GDP supplied Vertical LRAS=potential output Yp Aggregate Supply

The Short-Run Aggregate Supply Curve Profit per unit of output Nominal Wage Sticky Wages (slow to rise or drop) SRAS

Shifts of the Short-Run Aggregate Supply Curve ∆ Commodity Prices ∆ Nominal Wages ∆ Productivity Productivity rises (rightward) Productivity decrease (leftward)

The Long-Run Aggregate Supply Curve Flexible Wages Long Run LRAS Potential Output Factors that shift LRAS

LRAS The reason the SRAS was upward sloping was because nominal wages were sticky. So what if they were not? Or what if there was enough time for all wages to adjust? If the price of output increased by 5% and nominal wages had enough time to increase by 5%, there would be no profit incentive to increase output. All we would experience would be an increase in the aggregate price level. So the LRAS curve is vertical. But where is it located on the x-axis? LRAS touches the horizontal axis at the economy’s potential output, Yp: the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. Note: LRAS has been gradually shifting to the right over time. Our economy’s potential output has increased due to better technology, and a larger and more educated workforce.

From the Short Run to the Long Run

The economy from year to year fluctuates around the level of potential output Yp. Some years the economy is weak and real GDP lies below Yp. Other years the economy is extremely strong and real GDP lies above Yp. In the AD/AS model, the economy is always operating along the SRAS supply curve, but only sometimes does this coincide with the intersection of SRAS with LRAS. This model predicts however that, in the long run, the economy will adjust to where SRAS intersects LRAS at Yp. How? A strong labor market has rising demand for labor. There are very few workers that are unemployed. Employers are scrambling to find scarce employees. Eventually nominal wages rise and SRAS shifts to the left until current output is equal to Yp. A weak labor market has falling demand for labor. There are many unemployed workers. Employers find that they can get workers to accept lower wages. Eventually nominal wages fall and SRAS shifts to the right until current output is equal to Yp.