Aggregate Supply in the Short and Long Run

Short-run Aggregate Supply (SRAS) SRAS shows the relationship between the economy’s aggregate price level and the total quantity of final goods and services (aggregate output) producers are willing to supply. There is a positive relationship between price level and aggregate output (RGDP) –A higher price level translates into a higher profit per unit of output –Profit per unit of output is found by subtracting cost per unit from price per unit

o AS 1 P1P1 P2P2 Q1Q1 Q2Q2 a1a1 a2a2 A higher price level increases profits and output moving the economy from a 1 to a 2 Price Level Real domestic output SHORT-RUN AGGREGATE SUPPLY

o AS 1 P1P1 P2P2 Q1Q1 Q2Q2 a1a1 a2a2 A lower price level decreases profits and output moving the economy from a 1 to a 3 Price Level Real domestic output SHORT-RUN AGGREGATE SUPPLY P3P3 Q3Q3 a3a3

Short-Run Aggregate Supply In the short run production costs for a producer do not change –Sticky wages: because wages do not rise as rapidly as price levels, producers receive extra profit in the short run and therefore produce more. In the long run production costs do change. These changes result in a shift of the Aggregate Supply (AS) curve

Changes (shifts) in Short Run AS AS changes (shifts) when per unit production costs change for reasons other than a change in output. If costs increase then AS shifts left. If costs decrease AS shifts right There are three determinants of AS. Commodity prices Domestic resources foreign resources (oil / exchange rates)

Changes in Short Run AS Nominal Wages Nominal wages are fixed in the short-run, but as time passes wage contracts are renegotiated to account for increases in inflation An increase in wages increases per unit production costs and shifts AS leftward Productivity* Technology * Productivity is measured by real output divided by input. An increase in productivity lowers per unit production costs and the shifts the curve rightward.

AGGREGATE SUPPLY in the SHORT-RUN AND LONG-RUN Period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases Short Run - Period in which nominal wages and other input prices are fully responsive to previous changes in the price level Long Run -

o AS 1 P1P1 P2P2 Q1Q1 Q2Q2 a2a2 a1a1 AS 2 b1b1 Price Level Real domestic output SHORT RUN TO LONG RUN AGGREGATE SUPPLY A higher price level results in higher nominal wages and thus shifts the short-run aggregate supply to the left

o P3P3 Q3Q3 AS 1 P1P1 P2P2 Q1Q1 Q2Q2 a2a2 a3a3 a1a1 AS 2 b1b1 AS 3 c1c1 AS LR Price Level Real domestic output SHORT RUN TO LONG RUN AGGREGATE SUPPLY A lower price level results reduces nominal wages and shifts the short-run aggregate supply to the right

The Long-Run Aggregate Supply Curve uIn 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. uThe price level does not affect these variables. To illustrate this point the long- run AS is vertical.

The Long-Run Aggregate- Supply Curve... Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P1P1 P2P2 2. …does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level…

LRAS and the Production Possibilities Curve The Long Run AS curve and the production possibilities curve represent the same thing: what is this economy capable of producing when fully employing all available resources and technology. They both can also illustrate that we may be operating in the short-run above or below our full-employment level. An economy is operating at the full employment level only if it is on the PPC or if AD/AS intersects on the LRAS.

Short run Equilibrium Above and Below Full Employment Price Level SRAS RGDP LRAS FEQ2 PL2 PL1 PL3 Q3

Why the Short-run Aggregate Supply Curve Might Shift uShifts arising from a change in Labor costs. uShifts arising from a change in Capital costs. uShifts arising from a change in Natural Resource costs. uShifts arising from a change in Technology. uShifts arising from a change in the Expected Price Level.

uWhen people expect an increase in price levels they tend to set wages high. This shifts the short-run aggregate supply curve to the left. uWhen people expect a decrease in price levels they tend to set wages low. This shifts the short-run aggregate supply curve to the right. uThese shifts bring short-run changes in output back to the long-run level. Short Run to Long Run Aggregate Supply