Long Run Aggregate Supply

10 Key excerpts on "Long Run Aggregate Supply"

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  eBook - ePub

  Macroeconomics

  (With Study Guide CD-ROM)

  • Jagdish Handa(Author)
  • 2010(Publication Date)
  • WSPC

    (Publisher)

  y*) = 0. However, we cannot take it for granted that the real-world economies will meet these assumptions for each period of our study, when these periods are as short as, say, a month, a quarter, or a year. We, therefore, resorted to the analytical notion of the long run, which is defined as the stage in which these assumptions are met, so that the economy can be said to be at the full-employment (LR) level of output.

  Hence, the aggregate supply curve for the full-employment level of output is called the LR aggregate supply (LRAS) curve. It is applicable in the case of zero expectational errors, zero adjustment costs and lags, and equilibrium in the labor market and in production. It is strictly not applicable when these conditions are not met. However, the LR levels of output and employment can be used as a benchmark or reference state toward which the economy will tend to move. If it does not do so of its own volition or does not do so fast enough, macroeconomics (see Chapters 8 and 9 ) examines the policies that can induce such a movement.

  7.11.1 Changes in the actual rate of output over time

  The actual level of output alters over time because of changes in any or all of its three components since:

  As we have argued earlier, the full-employment level of output does change over time due to shifts in technology and in labor supply. The other two components of the actual level can also change and do change over the business cycle. In particular, they are positively related to the business cycle and tend to have positive values during a boom than during a recession. They can be changed by monetary and fiscal policies.

  7.12 The Rate of Unemployment

  This chapter has focused on the long-run analysis of output and employment. Changes in unemployment and its rate are the converse of those in employment, so that we now derive the implications of the long-run analysis for unemployment. Chapter 10

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  Economics for Investment Decision Makers

  Micro, Macro, and International Economics

  • Christopher D. Piros, Jerald E. Pinto(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  In other words, wages and prices that are inflexible or slow to adjust in the short run adjust to changes in the price level over the long run. Thus, over the long run, when the aggregate price level changes, wages and other input prices change proportionately so that the higher aggregate price level has no impact on aggregate supply. This is illustrated by the vertical long-run aggregate supply (LRAS) curve in Exhibit 5-14. As prices move from P 1 to P 2, the quantity of output supplied remains at Q 1 in the long run. The only change that occurs is that prices shift to a higher level (from P 1 to P 2). The position of the LRAS curve is determined by the potential output of the economy. The amount of output produced depends on the fixed amount of capital and labor and the available technology. This classical model of aggregate supply can be expressed as: where is the fixed amount of capital and is the available labor supply. The stock of capital is assumed to incorporate the existing technological base. 8 The available labor supply is also held constant, and workers are assumed to have a given set of skills. The long-run equilibrium level of output, Y 1 in Exhibit 5-14, is referred to as the full employment, or natural, level of output. At this level of output, the economy’s resources are deemed to be fully employed and (labor) unemployment is at its natural rate. This concept of a natural rate of unemployment assumes the macroeconomy is currently operating at an efficient and unconstrained level of production. Companies have enough spare capacity to avoid bottlenecks, and there is a modest, stable pool of unemployed workers (job seekers equal job vacancies) looking for and transitioning into new jobs. 3.3. Shifts in Aggregate Demand and Supply In the next two sections, the aggregate demand (AD) and aggregate supply (AS) models are used to address three critical macroeconomic questions: 1. What causes an economy to expand or contract? 2

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  eBook - PDF

  Economics

  A Contemporary Introduction

  • William A. McEachern(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  The long-run aggregate supply curve, LRAS, is a vertical line at potential GDP. Price level 110 Potential output LRAS 0 17.0 Real GDP (trillions of dollars) c AD ″ a b AD AD ′ 120 100 110 to 100, with no change in output. Note that these long-run movements are more like tendencies than smooth and timely adjustments. It may take a long time for resource prices to adjust, particularly when the economy faces a recessionary gap. But as long as wages and prices are flexible, the economy’s potential GDP is consistent with any price level. In the long run, equilibrium output equals long-run aggregate supply, which is also potential output. The equilibrium price level depends on the aggregate demand curve. 24-3b Wage Flexibility and Employment What evidence is there that a vertical line drawn at the economy’s potential GDP depicts the long-run aggregate supply curve? Except during the Great Depression, unemployment over the last century has varied from year to year but typically has returned to what would be viewed as a natural rate of unemployment—again, estimates range from 4 percent to 6 percent. An expansionary gap creates a labor shortage that eventually results in a higher nominal wage and a higher price level. But a recessionary gap does not necessarily generate enough downward pressure to lower the nominal wage. Studies indicate that Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 556 Part 6 Fundamentals of Macroeconomics nominal wages are slow to adjust to high unemployment.

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  Macroeconomics

  A Contemporary Introduction

  • William A. McEachern(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  The long-run aggregate supply curve, LRAS, is a vertical line at potential GDP. Price level 110 Potential output LRAS 0 17.0 Real GDP (trillions of dollars) c AD ″ a b AD AD ′ 120 100 110 to 100, with no change in output. Note that these long-run movements are more like tendencies than smooth and timely adjustments. It may take a long time for resource prices to adjust, particularly when the economy faces a recessionary gap. But as long as wages and prices are flexible, the economy’s potential GDP is consistent with any price level. In the long run, equilibrium output equals long-run aggregate supply, which is also potential output. The equilibrium price level depends on the aggregate demand curve. 10-3b Wage Flexibility and Employment What evidence is there that a vertical line drawn at the economy’s potential GDP depicts the long-run aggregate supply curve? Except during the Great Depression, unemployment over the last century has varied from year to year but typically has returned to what would be viewed as a natural rate of unemployment—again, estimates range from 4 percent to 6 percent. An expansionary gap creates a labor shortage that eventually results in a higher nominal wage and a higher price level. But a recessionary gap does not necessarily generate enough downward pressure to lower the nominal wage. Studies indicate that Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 224 Part 2 Fundamentals of Macroeconomics nominal wages are slow to adjust to high unemployment.

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  Economics

  The Definitive Encyclopedia from Theory to Practice [4 volumes]

  • David A. Dieterle(Author)
  • 2017(Publication Date)
  • Greenwood

    (Publisher)

  Aggregate supply (AS) shows how changes in both short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS) impact both the price level and real GDP. LRAS is composed of the productive capacity of an economic system or the production possibilities frontier, which is bound to the quantities of the factors of production and technology. SRAS is bound to the prices of the factors of production.

  The SRAS curve is upward-sloping because as prices increase, producers are more willing to supply goods and services (law of supply). The LRAS curve is vertical: a constant that is fixed to the quantity of the factors of production and technology or the production possibilities frontier.

  LRAS and SRAS are sensitive to changes in the quantities of the factors of production and technology. When there are more productive resources or an increase in technology, the LRAS and SRAS curves will increase or shift to the right in the AD/AS model, which will increase GDP and decrease the overall price level. The SRAS curve is sensitive to changes in the prices of the factors of production or temporary disruption in a supply-chain of an essential good, such as oil, and expectations about future inflation (this is really producers reacting to what they believe it will cost to replace their inventories). If the prices of the factors of production increase, or if producers expect future inflation, producers will supply less because it will be more costly to produce (some producers will exit the market) and the SRAS cure will shift to the left, resulting in an increase in the overall price level and a short-run decrease in real GDP. This combination of an increase in the overall price level and a short-run decrease in real GDP, called stagflation, is very difficult for the Federal Reserve or the government to cure.

  Figure 2. Short-run and long-run aggregate supply curves

  Many economists believe that the best way to combat stagflation is to wait until the prices of the factors of production adjust back down or the disruption in the supply chain is remedied. Conversely, if there is a decrease in the prices of the factors of production or if producers expect lower inflation in the future, SRAS will increase (more suppliers will enter the market) because it is cheaper to produce, which results in a decrease in the overall price level and a short-run increase in real GDP.

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  A Primer on Macroeconomics

  Policies and Perspectives

  • Thomas M. Beveridge(Author)
  • 2018(Publication Date)
  • Business Expert Press

    (Publisher)

  At point B, the opposite environment exists. Production level is low and the unemployment rate exceeds the natural rate of unemployment. Unsold production is piling up in warehouses. Cyclically unemployed workers, desperate for a job, may be willing to accept lower wages and reduced benefits. Other resources, sitting idle or underused, may become cheaper to acquire. In such a situation, productivity tends to increase, as workers who still have a job strive to avoid layoffs. Declining resource costs and increasing productivity will push the SRAS curve to the right.

  Conclusion : If the economy is in a situation similar to point B, then we would expect the underlying economic pressures to shift the SRAS curve to the right over time.

  At point E, the economy is neither overstressed nor underutilized. Labor and other resource markets are operating efficiently and sustainably, and firms have achieved their optimal inventory levels. There is no compelling pressure for change—the economy is at long-run equilibrium.

  Conclusion: Long-run equilibrium occurs at the aggregate price level where the SRAS curve and the LRAS curve intercept.

  The Self-Correcting Mechanism

  Let us suppose that the economy is initially at point E0 as shown in Figure 5.13 .

  The aggregate demand curve is AD0 , the short-run aggregate supply curve is SRAS0 , and the long-run aggregate supply curve is LRAS. The economy is in short-run and long-run equilibrium at point E0 .

  Now, perhaps because of increasing consumer and business confidence, aggregate demand shifts to AD 1 . At the initial price level, P 0 , there will be a mismatch between aggregate demand and short-run aggregate supply,

  with declining inventories and swelling waiting lists for orders. The aggregate price level will start to increase. Following the short-run equilibrating process described in the previous section, the economy will achieve a new short-run equilibrium at point A. At this point, the economy is producing at an output level, y

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  Economics For Dummies, UK Edition

  • Peter Antonioni, Sean Masaki Flynn(Authors)
  • 2010(Publication Date)
  • For Dummies

    (Publisher)

  Suppose that a firm has printed up catalogues listing the prices of the things it sells. This firm distributes catalogues only once a year, which means it is committed to selling to customers at these prices until the next catalogue is sent out. In such a situation, a firm adjusts its production to meet whatever amount of demand happens to come along at these fixed prices. If a lot of people show up to buy at these prices, the firm increases production, typically by hiring more employees. If very few people show up to buy, it reduces production, typically by hiring fewer employees.

  Figure 6-4 depicts a situation in which firms have committed to a fixed set of prices and can respond to changes in demand only by adjusting their production levels. The figure shows the horizontal short-run aggregate supply curve (SRAS) , which is not a curve at all but a straight line. This ‘curve’ corresponds to price level P o because the firms, in the short run, can’t adjust their prices. Movements right and left along the SRAS curve capture the increases and decreases in output that firms have to make as demand for their products varies at the fixed price level.

  Figure 6-4: The short-run aggregate supply curve.

  In the short run, it makes sense to think of the firm as having more control over its production levels than its prices, which leads to modelling the SRAS

  curve as horizontal. In the long run, potential output is capped at a level given by a number of underlying long-run factors. In between, we have a number of models of various degrees of elaborateness explaining what happens. Generally at some point, these models all agree: the

  SRAS

  first becomes upward sloping (implying that prices and output rise together) and then vertical. What we’re going to do here is to skip the middle bit in the name of simplicity. Of course, in reality economies don’t just jump from a horizontal

  SRAS to a vertical LRAS

  , from growth to recession, or from one price level to another. However, the model is simpler to understand, without losing the essential features of the analysis, if we pretend for the moment that this does happen to economies. If you’re okay with making that a deal, we’re going to use only the initial horizontal curve and the final vertical curve, calling the former the

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  eBook - ePub

  Economics For Dummies

  Book + Chapter Quizzes Online

  • Sean Masaki Flynn(Author)
  • 2023(Publication Date)
  • For Dummies

    (Publisher)

  * . There is neither a surplus nor a shortage that could cause prices to change.

  The SRAS curve is horizontal at price

  P0

  to reflect the fact that after the economy reaches its equilibrium (where

  AD0

  intersects the LRAS at output level

  Y*

  ), the prices that are determined at that level are fixed in the short run; they can’t change immediately, even if a demand shock happens to come along.

  For instance, suppose that the aggregate demand curve shifts left from

  AD0

  to

  AD1

  because of a negative demand shock of some sort. Because prices are fixed in the short run at

  P0 ,

  the economy’s first response is to move from Point A to Point B. In other words, because prices are fixed, production falls from

  Y*

  down to

  YLow

  as firms respond to decreased demand by cutting production. (Small arrows indicate the movement of the economy from Point A to Point B. )

  © John Wiley & Sons, Inc.

  FIGURE 16-5: Short-run and long-run responses to a negative demand shock.

  At Point B, the economy is operating below full employment, implying that a lot of workers are unemployed. This high level of unemployment causes wages to fall. As wages fall, firms’ costs also fall, allowing them to cut prices to attract more customers.

  Falling prices cause increased aggregate demand for goods and services, which eventually moves the economy all the way from Point B to Point C . (Arrows on the graph indicate this movement.) When the economy reaches point C, it’s once again producing at full employment,

  Y*

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  Chinese Economists on Economic Reform - Collected Works of Lou Jiwei

  • Lou Jiwei, China Development Research Foundation(Authors)
  • 2013(Publication Date)
  • Taylor & Francis

    (Publisher)

  Simply put, ‘aggregate supply’ refers to those products and services that have an ‘actual practical-use value’ that can be produced by existing production capacities within one year. It can be roughly expressed in terms of the expected gross national product (GNP) as measured in constant prices, or by the expected national income. The thing that aggregate supply focuses on is the production capacity of such productive factors as assets, labor, land, imported materials, and foreign capital inflows. Within any given year, these are limited. Each is constrained by the quantity and quality of all other factors. For example, a quantitative maximum is imposed on imported materials and the amount of our foreign debt by the smallest extent of foreign exchange reserves and the highest amount of debt-servicing. ‘Aggregate supply’ refers to the maximum amount of ‘well-being’ that can be produced by the full capacity of production factors, after they are combined in optimal fashion. It is also referred to as the ‘production-possibility frontier’ or the ‘potential production level.’ We should say that referring to the maximum well-being of people is more accurate, since it excludes from the figures production of overstocked things that people don’t need, either for immediate or long-term consumption (as investment).

  From the perspective of optimization theory, the production capacity of each production factor provides a group of constraints. Different types of production and consumption structures use up differing amounts of the factors of production. While one type may consume more materials, another type may consume more labor. The so-called aggregate supply pursues optimal structure and also maximum production under this optimal structure. When a production and consumption structure enables as many types of products as possible to reach a balance between production and consumption, and at the same time enables as many factors of production as possible to reach a balance between capacity and use, the structure can be thought of as optimal. When the entire society carries out production and consumption according to this structure and expands production and consumption to the extent that bottleneck elements in production are at capacity and material production and consumption cannot be expanded further within a given year, we say aggregate supply has reached its ‘production-possibility frontier.’ These are the two implications embodied in the term ‘aggregate supply:’ optimization of structure at maximum size.

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  Macroeconomics

  Principles & Policy

  • William Baumol, Alan Blinder, John Solow, , William Baumol, Alan Blinder, John Solow(Authors)
  • 2019(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 10 Bringing in the Supply Side: Unemployment and Inflation? 197 economy—as measured by its available supplies of labor and capital—the more it is capable of producing. Thus: As the labor force grows or improves in quality, and as investment increases the capital stock, the aggregate supply curve shifts outward to the right, meaning that more output can be produced at any given price level. So, for example, the great investment boom of the late 1990s, by boosting the supply of capital, left the U.S. economy with a greater capacity to produce goods and services—that is, it shifted the aggregate supply curve outward. The investment slump of the late 2000s did precisely the reverse. These factors, then, are the major “other things” that we hold constant when drawing an aggregate supply curve: nominal wage rates, prices of other inputs (such as energy), technology, labor force, and capital stock. A change in the price level moves the economy along a given supply curve, but a change in any of these determinants of aggregate quantity supplied shifts the entire supply schedule. 10-2 EQUILIBRIUM OF AGGREGATE DEMAND AND SUPPLY The previous chapter taught us that the price level is a crucial determinant of whether equilibrium GDP falls below full employment (a “recessionary gap”), precisely at full employment, or above full employment (an “inflationary gap”). We can now analyze which type of gap, if any, will occur in any particular case by combining the analysis of aggregate supply we just completed with the analysis of aggregate demand from the last chapter. Figure 3 displays the simple mechanics. In the figure, the aggregate demand curve DD and the aggregate supply curve SS intersect at point E, where real GDP (Y) is $6,000 billion and the price level (P) is 100.

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