UNIT 3: Aggregate Supply (Long run and Short run)

                                                         Aggregate Supply

             The level of real GDP (GDPr) that firms will produce at each price level (PL)

                                                        Long run v. Short run

-Long run:

ü  Period of time where input prices are completely flexible and adjust to changes in the price level.

ü  In the long run, the level of real GDP supplied is independent of the price level.

-Short run:

ü  Period of time where input prices are sticky and do not adjust to changes in price level.

ü  In the short run, the level of real GDP supplied is directly related to the price level (PL).

                         Long run Aggregate Supply (LRAS)

·         The long run aggregate supply or LRAS marks the level of full employment in the economy (analogous to ppc).

·         Because input prices are completely flexible in the long run, changes in price level do not change firm’s real profits and therefore do not change firm’s level of output. This means that LRAS at the economy’s level of full employment.

                                         Changes in short run aggregate supply (SRAS)

·         An increase in SRAS is seen as a shift to the right. SRAS >

·         A decrease in SRAS is seen as a shift to the left SRAS <

·         The key to understanding shifts in SRAS is per unit cost of production.

Per unit production cost = total input cost divided by total output.

                             Determinants of SRAS

                      All affects unit production cost.

Ø  Input prices.

Ø  Productivity.

Ø  Legal-institutional environment.

            Input prices

·         Domestic resource prices.

-wages (75% of all business costs)

-cost of capital.

-raw materials (commodity prices)

·         Foreign resource prices

·         Market power

·         Increases in resource prices = SRAS shift to the <

·         Decrease in resource prices = SRAS shift to the >

                                                 Productivity

§  Productivity = total output divided by total inputs.

§  More productivity = lower unit production cost = SRAS shifting >

§  Lower productivity = higher unit production cost = SRAS shifting <

                                               Legal institutional environment

o   Taxes and subsidies.

-          Taxes ($ to gov’t) on business increase per unit production cost = SRAS shifting <

-Subsidies ($ from gov’t) to business reduce per unit production cost = SRAS shifting >

o   Government Regulation.

-          Government regulation creates a cost of compliance = SRAS shifting <

-          Deregulation reduces compliances costs = SRAS shifting >

                                                            Full Employment

 Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point

                                                             Recessionary gap

A recessionary gap exists when equilibrium occurs below full employment output

                                                             Inflationary gap

An inflationary gap exist when equilibrium occurs beyond full employment output

                                                                  Nominal wages

                          The amount of money received by a worker per unit of time.

                                                                       Real wages

            It is the amount of goods and services a worker can purchase with their nominal wage. It is the purchasing power of your nominal wage.

                                                                      Sticky wages

It is the nominal wage level that is set according to an initial price level and does not vary due to labor contracts and other restrictions.