Extending The Analysis Extending The Analysis Of AS To The Long Run Alban William Housego Phillips WithPhillip & Laffer

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 PL 1 [3%] PL 1 [3%] SRAS E1E1E1E1 Y Price Level Real domestic output Extending AS [SRAS] to the LR [LRAS] AD LRAS We have looked at the AS/AD model In detail. Now let’s extend that model In order to distinguish between short- run and long-run aggregate supply.

S hort R un S hort R un – a period in which nominal wages (input cost) remain fixed as PL (profits) increase or decrease. SRASLRAS SRAS and LRAS L ong R un– a period in which nominal wages are fully responsive to PL 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 in the SR Many workers are hired under fixed-wage contracts (Mr. Walton) and can not demand higher wages until their contract expires.

GROWTH IN THE AS/AD MODEL Capital Goods Consumer Goods Price Level Real GDP LRAS1LRAS2 Y1Y1Y1Y1 Y2Y2Y2Y2 U a b c d Economic growth is illustrated in the AS/AD model by a vertical long-run AS line. 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.

Factors that cause economic growth Capital Goods Consumer Goods Price Level Real GDP LRAS1LRAS2 Y1Y1Y1Y1 Y2Y2Y2Y2 1. Increase in resources - Economic Growth Economic Growth 2. Better resource quality - 2. Better resource quality - 3. Technological advances - advances - U a b c d

Economic Growth & Demand Pull Inflation

Price Level Real GDP o PL 1 LRAS 1 AD 2 Y1Y1 LRAS 2 Y2Y2 AD 1 SRAS 1 PL 2 As LRAS shifts to the right it drags the AD curve with it. And this increases the PL.

0 PL 1 [3%] PL 1 [3%] SRAS E1E1E1E1 Y Price Level Real domestic output AD LRAS WhenPL is anticipated, equilibrium is the same for both the When PL is anticipated, equilibrium is the same for both the SRAS curve & the LRAS curve at potential output.

6%6%6%6% 3%3%3%3% 4 % 4 % AS 1 AD 1 E1E1E1E1 E2E2E2E2 E3E3E3E3 LRAS 3%3%3%3% With more profits, firms attempt to increase the quantity supplied. They offer their workers overtime, Entice homemakers & retirees into the labor force, and hire and train the structurally Unemployed, which overextends the economy. AD 2 But when PL (inflation) is unanticipated, in the short run, output prices (profits) increase while input prices (cost/wages) remain fixed. Unemployment

6%6%6%6% 3%3%3%3% 4 % 4 % AS 1 AS 2 AD 1 E1E1E1E1 E2E2E2E2 E3E3E3E3 LRAS 3%3%3%3% Since nominal wages are one of the determinants of AS, the SRAS curve will shift leftward leading to a higher PL, but bringing the economy back into equilibrium. You’re crazy if you think we’re going to accept 3% wage increases while prices are going up 6%. AD 2 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 real wages that they enjoyed.

0 Yr 1 [3%] Yr 1 [3%] E1E1E1E1 Y Price Level Real domestic output AD LRAS This is a naturally occurring trend in the market and is the reason why PL continually increase from year to year. Yr 2 [3%] Yr 2 [3%] Yr 3 [3%] Yr 3 [3%] SRAS

o PL 1[ 2 %] SRAS 1 LRAS AD 1 E1E1E1E1 Y1Y1Y1Y1 Price Level Real domestic output E2E2E2E2 PL 2[ 5 %] AD 2 Y2Y2Y2Y2 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 its vertical AS curve.

o PL 1[ 2 % ] SRAS 1 LRAS AD 1 E1E1E1E1 Y1Y1Y1Y1 Price Level Real GDP E2E2E2E2 PL 2[ 5 % ] AD 2 SRAS 2 E3E3E3E3 Y2Y2Y2Y2 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

Y 2 10 % o PL 1[2%] E1E1 Y1Y1Y1Y1 Price Level Real domestic output E2E2E2E2 PL 2 (10 % ) Cost-push inflation occurs when an increase in production cost causes a shift in SRAS to the left. This shift in SRAS causes an increase in the PL, and widespread layoffs in the labor force. This economic stagnation mixed with inflation is called stagflation. SRAS 2 LRAS AD 1 SRAS 1

Y2Y2Y2Y2 o PL 1 [2%] E1E1E1E1 Y1Y1Y1Y1 Price Level Real domestic output E2E2E2E2 PL 2 [10%] PL 2 [10%] PL 3 [12%] PL 3 [12%] If government attempts to fight unemployment by increasing AD then inflation will spiral out of control. E3E3E3E3 10% LRAS AD 2 SRAS 2 SRAS 1 AD 1

Y2Y2Y2Y2 o PL 1 2 % PL 1 [2 % ] E1E1E1E1 Y1Y1Y1Y1 Price Price Level Real domestic output E2E2E2E2 PL 2 10 % PL 2 [10 % ] 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. 10 % SRAS 1 AD 1 SRAS 2 LRAS

Y2Y2Y2Y2 o PL 1 2 % PL 1 [2 % ] E1E1E1E1 Y1Y1Y1Y1 Price Price Level Real domestic output E2E2E2E2 PL 2 10 % PL 2 [10 % ] The Federal Reserve can help by tightening the money supply. This will cause the recession to worsen, but the lack of currency will cause its value to increase, leading to PL declining. 10 % SRAS 1 AD 1 SRAS 2 LRAS

Learn economics. Don’t be “economic girlie men.” A Word From Arnold