Lesson 7-2 Aggregate Supply

1. Lesson 7-2 Aggregate Supply

2. Aggregate Supply: the Long Run and The Short Run Basic Definitions The short run in macroeconomic analysis is a period in which wages and some other prices are sticky. A sticky price is a price that is slow to adjust to its equilibrium level, creating sustained periods of shortage or surplus. The long run in macroeconomic analysis is a period in which wages and prices are flexible

3. The Long Run Long-run Aggregate Supply The long-run aggregate supply curve relates the level of output produced by firms to the price level in the long run. In the long run, the economy can achieve its natural level of employment and potential output at any price level. The long-run aggregate supply curve (LRAS) is a vertical line at the economy’s potential level of output (Y P ).

4. The Long Run (cont.) Equilibrium Levels of Price and Output in the Long Run The intersection of long-run aggregate demand and long-run aggregate supply gives the equilibrium real GDP and price level in the long run. Shifts in aggregate demand only result in price level changes in the long run.

5. The Short Run Short-Run Aggregate Supply A shift in aggregate demand in the short run will be accompanied by some sticky prices. An increase in aggregate demand will probably increase the prices firms receive but not the wages they must pay. Firms will probably want to increase output.

6. Some formerly frictionally and structurally unemployed workers may be employed to allow such increases in production. Thus, output can be above the potential or natural output temporarily until the wages rise to accommodate the increase in aggregate demand. A decrease in aggregate demand in the short run will probably cause a reduction in prices received by firms but no change in the wage rates. This leads to laying off workers and reducing output below the potential level until the wages adjust to the lower aggregate demand.

7. The short-run aggregate supply curve is a graphical representation of the relationship between production and the price level in the short run. The short-run aggregate supply curve (SRAC) is upward-sloping because of sticky wages and some prices. Among factors held constant in drawing a short-run aggregate supply curve are the capital stock, the stock of natural resources, the level of technology, and the prices of factors of production. The movement along the short-run aggregate supply curve produced by a change in the price level is called a change in the aggregate quantity of goods and services supplied.

8. A change in the quantity of goods and services supplied at every price level in the short run is a change in short-run aggregate supply. Changes in the factors held constant in drawing the short-run aggregate supply curve shift the curve and may also shift the long-run aggregate supply curve as well.

9. Reasons for Wage and Price Stickiness Wage Stickiness Wage contracts fix nominal wages for a set period, sometimes several years. Minimum wages prevent some wages from falling. Price Stickiness Rigidity of wages may cause firms to resist changing prices. There may be adjustment costs associated with changing prices.