Long Run Aggregate Supply

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.

SRAS AD LRAS FE Price Level PL1 [3%] E1 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. LRAS SRAS AD Price Level PL1 [3%] E1 FE Real GDP

SRAS AD LRAS FE Price Level PL1 [3%] E1 In the long run aggregate supply is a Vertical line at full employment. LRAS SRAS AD Price Level PL1 [3%] 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. c LRAS1 LRAS2 a Capital Goods U Price Level b d Y1 Y2 Consumer Goods Real GDP

Factors that cause economic growth 1. Increase in resources - c LRAS1 LRAS2 2. Better resource quality - a 3. Technological advances - Capital Goods U Price Level But what is the difference between LRAS & SRAS? Y1 b d Y2 Consumer Goods 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. SRAS1 Price Level PL2 PL1 AD2 AD1 o Y1 Y2 Real GDP

SRAS AD LRAS FE Price Level 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%] E1 FE Real GDP

But when PL (inflation) is unanticipated, output prices (profits) will increase, in the short run, while input prices (cost/wages) remain fixed. LRAS AS1 AD1 AD2 Remember, an Increase in quantity Supply is shown as Moving up a fixed AS Curve. 6% E3 E2 3% E1 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. 4% 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. LRAS AS2 AS1 6% E3 E2 You’re crazy if you think we’re going to accept 3% wage increases while prices are going up 6%. 3% E1 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. 4% 3%

SRAS AD LRAS Y This is a naturally occurring trend in the market and is the reason why PL continually increase from year to year. LRAS SRAS Yr 3 [3%] Yr 2 [3%] Price Level Yr 1 [3%] E1 AD 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 moved the economy along its vertical AS curve. LRAS AD2 SRAS1 AD1 Price Level PL2[5%] E2 PL1[2%] E1 o Y1 Y2 Real domestic output

For a while, the economy can operate beyond its FE level of output 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. LRAS SRAS2 AD2 SRAS1 Price Level AD1 E3 PL2[5%] E2 PL1[2%] E1 o 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 AD1 SRAS2 SRAS1 PL2(10%) E2 Price Level PL1[2%] E1 o Y2 10% Y1 Real domestic output

If government attempts to fight unemployment by increasing AD then inflation will spiral out of control. SRAS2 AD2 LRAS AD1 SRAS1 E3 Price Level PL3 [12%] E2 PL2 [10%] PL1[2%] E1 o Y2 Y1 Real domestic output 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. LRAS AD1 SRAS1 SRAS2 E2 PL2[10%] Price Level PL1[2%] E1 o Y2 Y1 Real domestic output 10%

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 AD1 SRAS1 SRAS2 E2 PL2[10%] Price Level PL1[2%] E1 o Y2 Y1 Real domestic output 10%

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