1. Long Run
Aggregate Supply

2. 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.

3. 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

4. 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

5. 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

6. 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

7. 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.

8. 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.

9. Economic Growth & Demand Pull Inflation

10. 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

11. 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

12. 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

13. 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%

14. 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

15. 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

16. 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

17. Cost-Push Inflation & Stagflation

18. 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

19. 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%

20. 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%

21. 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%

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