The long-run aggregate supply

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AGGREGATE SUPPLY
The aggregate supply curve shows the
relationship between the aggregate
price level and the quantity of aggregate
output.
AGGREGATE SUPPLY CURVE
Aggregate Supply is the amount of real GDP that will be
made available by sellers at various price levels.
Aggregate Supply looks different in the Long Run and the
Short Run:
 In the Long Run, classical economists assume the economy
operates at full employment (maximum output), independent of
the price level.
 In the Short Run, businesses will increase supply if the price level
increases.
POSITIVE RELATIONSHIP
There is a positive relationship in the
short run between price level and
the quantity of aggregate output
supplied.
THE AGGREGATE SUPPLY CURVES
The Slope of the Short-Run Aggregate Supply (SAS) Curve
The SAS curve is upward sloping because of:
 Auction markets
 Prices are determined by demand and supply and supply curves are
upward sloping
 Posted price markets
 Also called quantity-adjusting markets, markets in which firms respond to
changes in demand by changing production instead of changing their
prices
 Firms tend to increase their markup when demand increases
SHIFTS IN THE SAS CURVE
Price level
SAS1
SAS0
 Shifts in the SAS are caused by
changes in:
• Input prices
• Productivity
• Import prices
• Excise and sales taxes
SAS2  When production costs increase, the
SAS curve shifts up
 In general:
%Δ in price level =
%Δ in wages – %Δ in productivity
Real output
THE LONG-RUN AGGREGATE SUPPLY CURVE
 The long-run aggregate supply (LAS) curve shows the long-run
relationship between output and the price level
 The position of the LAS curve depends on potential output
which is the amount of goods and services an economy can
produce when both capital and labor are fully employed
 The LAS curve is vertical because potential output is
unaffected by the price level
THE LAS CURVE
Price level
Potential output is assumed to be in the
middle of a range bounded by high and
low levels of potential output
LAS
SAS
Underutilized B
A resources
Low-level
potential
output
Overutilized
C
resources
High-level
potential
output
Real
output
• When resources are overutilized (point C), factor prices
may be bid up and the SAS
shifts up
• When resources are underutilized (point A), factor prices
may decrease and SAS shifts
down
LAS
• Estimating potential output is
inexact, so it is assumed to be the
middle of a range bounded by a
high level of potential output and a
low level of potential output.
C
• The relationship between
Price Level
B
A
potential and actual output – where
the economy is on SAS – determines
shifts in SAS.
SAS
• When resources are over-utilized
Underutilized
resources
(point C), factor prices may be bid
up and the SAS shifts up.
Overutilized
resources
• When resources are under-utilized
Low-level
potential
output
High-level
potential
output
Real
output
(point A), factor prices may decrease
and SAS shifts down.
• When LAS = SAS (point B), there is
no pressure for prices to rise or fall.
SHIFTS IN THE LAS CURVE
Price level
LAS0
LAS1
LAS2
Real output
Increases in the LAS are
caused by increases in:
 Capital
 Resources
 Growth-compatible
institutions
 Technology
 Entrepreneurship
LRAS
The long-run aggregate supply curve shows
the relationship between the aggregate
price level and the quantity of aggregate
output supplied that would exist if all
prices, including nominal wages, were
fully flexible
Do you remember the debate between Classical and Keynes?
A RANGE FOR POTENTIAL OUTPUT AND THE LAS
CURVE
The position of the long-run aggregate
supply curve is determined by potential
output.
Potential output – the amount of goods
and services an economy can produce
when both labor and capital are fully
employed.
Was this in your textbook?
LONG-RUN AGGREGATE SUPPLY CURVE
ACTUAL AND POTENTIAL OUTPUT
SHORT-RUN EQUILIBRIUM IN THE AD/AS MODEL
Price level
Short-run equilibrium is where the
SAS and AD curves intersect and
point E is short-run equilibrium
SAS
P1
P0
F
AD1
E
AD0
Y0
Y1
A shift in the aggregate
demand curve to the right
changes equilibrium from E
to F, increasing output from
Y0 to Y1 and increasing price
level from P0 to P1
Real output
SHORT-RUN EQUILIBRIUM IN THE AD/AS MODEL
Price level
SAS1
P2
P0
SAS0
G
A shift up in the short-run
aggregate supply curve
changes equilibrium from E to
G, decreasing output from Y0
to Y2 and increasing price level
from P0 to P2
E
AD
Y2
Y0
Real output
LONG-RUN EQUILIBRIUM IN THE AD/AS MODEL
Price level
Long-run equilibrium is where the
LAS and AD curves intersect
LAS
P1
H
P0
E
A shift in the aggregate
demand curve changes
equilibrium from E to H,
increasing the price level
from P0 to P1 but leaving
output unchanged
AD1
AD0
YP
Real output
APPLICATION:
A RECESSIONARY GAP IN THE AD/AS MODEL
Price level
LAS
SAS1
SAS0
• A recessionary gap is the
amount by which equilibrium
output is below potential output
• At point A, some resources are
unemployed and the
recessionary gap is YP – Y1
A
P1
E
P0
Gap
Y1
AD0
YP
Real output
Eventually wages and prices
decrease and SAS shifts down
to return the economy to a long
and short-run equilibrium at E
APPLICATION:
AN INFLATIONARY GAP IN THE AD/AS MODEL
Price level
• An inflationary gap is the
amount by which equilibrium
output is above potential output
LAS
SAS0
P0
E
B
SAS2
P2
Gap
YP
AD0
Y2
Real output
• At point B, resources are being
used beyond their potential and
the inflationary gap is Y2 – YP
Eventually wages and prices
increase and SAS shifts to
return the economy to a long
and short-run equilibrium at E
FROM THE SHORT RUN TO THE LONG RUN
Leftward Shift of the Short-run Aggregate Supply Curve
FROM THE SHORT RUN TO THE LONG RUN
Rightward Shift of the Short-run Aggregate Supply Curve
AGGREGATE DEMAND POLICY
 A primary reason for government policy makers’
interest in the AS/AD model is that monetary or
fiscal policy shifts the AD curve
Monetary policy involves the Federal Reserve
Bank changing the money supply and interest
rates
Fiscal policy is the deliberate change in either
government spending or taxes to stimulate or
slow down the economy
APPLICATION:
EXPANSIONARY FISCAL POLICY IN THE AD/AS
MODEL
Price level
• If the economy is at point A,
there is a recessionary gap
equal to YP – Y0
LAS
P1
• The appropriate fiscal policy is
to increase government spending
and/or decrease taxes
E
P0
A
Gap
Y0
AD0
YP
AD1
AD shifts to the right and output
returns to potential output YP
and prices
increase to P1
Real output
APPLICATION:
CONTRACTIONARY FISCAL POLICY IN THE AD/AS MODEL
Price level
LAS
• The appropriate fiscal policy is
to decrease government
spending and/or increase taxes
B
P2
P1
• If the economy is point B, there
is an inflationary gap Y2 – YP
E
AD0
Gap
YP
AD2
Y2
Real output
AD shifts to the left, output
returns to potential output YP
and inflation is prevented
LIMITATIONS OF THE AS/AD MODEL
 The AS/AD model assumes away many possible
feedback effects that can significantly affect the
macroeconomy and lead to quite different
conclusions
 Implementing fiscal policy through changing taxes
and government spending is a slow legislative
process
• There is no guarantee that government will do what
economists say is necessary
LIMITATIONS OF THE AS/AD MODEL
 Potential output (the level of output that the economy is
capable of producing without generating inflation) is difficult to
estimate
 We do have ways to get a rough idea of where it is
 There are many other possible interrelationships in the
economy that the model does not take into account
 The aggregate economy can become dynamically unstable, so
a shock can set in motion changes that will not automatically
be self-correcting
LIMITATIONS OF THE AS/AD MODEL
 There are two ways to think about the effectiveness of fiscal
policy: in the model and in reality
 The effectiveness of fiscal policy depends on the
government’s ability to perceive and to react appropriately to a
problem
 Countercyclical fiscal policy is fiscal policy in which the
government offsets any change in aggregate expenditures that
would create a business cycle
 Fine-tuning is used to describe such fiscal policy designed to
keep the economy always at its target or potential level of
income
CHAPTER SUMMARY
 The key idea of the Keynesian AS/AD model is that in the
short run the economy can deviate from potential output
 The AS/AD model consists of the aggregate demand curve,
and the short-run aggregate supply curve, and the long-run
aggregate supply curve
 Short-run equilibrium is where the SAS and AD curves
intersect; Long-run equilibrium is where the AD and LAS
curves intersect
 Aggregate demand management policy attempts to influence
the level of output in the economy
CHAPTER SUMMARY
 Fiscal policy works by providing a deliberate countershock to
offset unexpected shocks to the economy
 Macroeconomic policy is difficult to conduct because:
• Implementing fiscal policy is a slow process
• We don’t really know where potential output is
• There are interrelationships not included in the model
• The economy can become dynamically unstable

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