Page 335 - Economics

CONFIRMING PAGES

CHAPTER 15
287
Extending the Analysis of Aggregate Supply
FIGURE 15.1 Short-run and long-run aggregate supply. (a) In the short run, nominal wages do not
respond to price-level changes and based on the expectation that price level P 1 will continue. An increase in the price level
from P 1 to P 2 increases profits and output, moving the economy from a 1 to a 2 ; a decrease in the price level from P 1 to P 3
reduces profits and real output, moving the economy from a 1 to a 3 . The short-run aggregate supply curve therefore slopes
upward. (b) In the long run, a rise in the price level results in higher nominal wages and thus shifts the short-run aggregate
supply curve to the left. Conversely, a decrease in the price level reduces nominal wages and shifts the short-run aggregate
supply curve to the right. After such adjustments, the economy obtains equilibrium of points such as b 1 and c 1 . Thus, the
long-run aggregate supply curve is vertical at the full-employment output.
AS LR AS 2
AS 1 AS 1
a 2 b 1 a 2 AS 3
P 2 P 2
Price level P 1 a 1 Price level P 1 a 1

a 3 a 3
P 3 P 3 c 1

0 Q 3 Q f Q 2 0 Q f
Real domestic output Real domestic output
(a) (b)
Short-run aggregate supply Long-run aggregate supply
Q . Increased unemployment and a higher unemployment its full-employment level Q , and the unemployment rate
f
3
rate accompany the decline in real output. At output Q rises to its natural rate.
3
the unemployment rate is greater than the natural rate of What is the long-run outcome of a decrease in the price
unemployment associated with output Q . level? Assuming eventual downward wage flexibility, a de-
f
cline in the price level from P to P in Figure 15.1 b works
1
3
Long-Run Aggregate Supply in the opposite way from a price-level increase. At first the
The outcomes are different in the long run. To see why, economy moves from point a to a on AS . Profits are
1
3
1
we need to extend the analysis of aggregate supply to ac- squeezed or eliminated because prices have fallen and nom-
count for changes in nominal wages that occur in response inal wages have not. But this movement along AS is the
1
to changes in the price level. That will enable us to derive short-run supply response. With enough time the lower
the economy’s long-run aggregate supply curve. price level P (which has increased real wages) results in a
3
By definition, nominal wages in the long run are fully drop in nominal wages such that the original real wages are
responsive to changes in the price level. We illustrate the restored. Lower nominal wages shift the short-run aggre-
implications for aggregate supply in Figure 15.1 b. Again, gate supply curve rightward from AS to AS , and real out-
3
1
suppose that the economy is initially at point a ( P and put returns to its full-employment level of Q at point c .
1
1
1
f
Q ). As we just demonstrated, an increase in the price level By tracing a line between the long-run equilibrium
f
from P to P will move the economy from point a to a points b , a , and c , we obtain a long-run aggregate supply
2
2
1
1
1
1
1
along the short-run aggregate supply curve AS . In the curve. Observe that it is vertical at the full-employment
1
long run, however, workers discover that their real wages level of real GDP. After long-run adjustments in nominal
(their constant nominal wages divided by the price level) wages, real output is Q regardless of the specific price
f
have declined because of this increase in the price level. level. (Key Question 3)
They restore their previous level of real wages by gaining
nominal wage increases. Because nominal wages are one of
the determinants of aggregate supply (see Figure 10.5 ), the Long-Run Equilibrium in
short-run supply curve then shifts leftward from AS to the AD-AS Model
1
AS , which now reflects the higher price level P and the Figure 15.2 helps us understand the long-run equilibrium in
2
2
new expectation that P , not P , will continue. The left- the AD-AS model, now extended to include the distinction
1
2
ward shift in the short-run aggregate supply curve to AS between short-run and long-run aggregate supply. (Hereaf-
2
moves the economy from a to b . Real output falls back to ter, we will refer to this model as the extended AD-AS model,
1
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