22.2Aggregate demand and aggregate supply: the long run and the short run
- Distinguish between short run and long run as these terms are used in macroeconomics.
- Draw a hypothetical long-run aggregate supply curve, and explain what it shows about the natural levels of employment and output at various price levels, given changes in aggregate demand.
- Draw a hypothetical short-run aggregate-supply curve, explain why it slopes upward, and explain why it might change; that is, distinguish between a change in the aggregate quantity of goods and services provided and a change in aggregate supply in the short run.
- Discuss various explanations for price and wage stickiness.
- Explain and illustrate what is meant by short-run equilibrium, and relate equilibrium to potential output.
In macroeconomics we try to understand two types of equilibrium, one corresponding to the short run and the other corresponding to the long run. EITHERshort termIn macroeconomic analysis, a period in which wages and some other prices are sticky and unresponsive to changing economic conditions.in macroeconomic analysis it is a period in which wages and some other prices do not respond to changes in economic conditions. In certain markets, as economic conditions change, prices (including wages) may not adjust fast enough to maintain equilibrium in those markets. Afixed priceA price that takes time to adjust to its equilibrium level, creating prolonged periods of shortage or surplus.it is a price that takes time to adjust to its equilibrium level, creating prolonged periods of shortage or surplus. Wage and price rigidity prevents the economy from reaching its natural level of potential employment and output. On the contrary, thelong-termIn macroeconomic analysis, the period in which wages and prices are flexible.in macroeconomic analysis it is a period in which wages and prices are flexible. In the long run, employment will move to its natural level and real GDP to potential.
We begin with a discussion of long-run macroeconomic equilibrium, because this type of equilibrium allows us to view macroeconomics after full market adjustment has been achieved. Conversely, in the short run, price or wage stickiness is an obstacle to full adjustment. Why these deviations from the potential level of output occur and what the implications are for the macroeconomy will be discussed in the section on short-run macroeconomic equilibrium.
As we saw in a previous chapter, the natural level of employment occurs when the real wage adjusts so that the quantity of labor demanded equals the quantity of labor supplied. When the economy reaches its natural level of employment, it reaches its potential level of output. We will see that real GDP eventually becomes potential because all wages and prices are assumed to be flexible in the long run.
Long Term Aggregate Supply
olong run aggregate supply curve (LRAS)Graphic representation that relates the level of production of companies with the price level in the long term.relates the level of output of firms to the price level in the long run. In Panel (b) ofFigure 22.4 "Natural employment and long-term aggregate supply", the long-run aggregate supply curve is a vertical line at the potential level of output in the economy. There is only one real wage at which employment reaches its natural level. In Panel (a) ofFigure 22.4 "Natural employment and long-term aggregate supply", only a real wage of ωmigenerates natural employmentUEmi. However, the economy could achieve this real wage with any of an infinitely large set of combinations of money wages and price levels. Suppose, for example, that the equilibrium real wage (the ratio of wages to the price level) is 1.5. We could have this with a money wage level of 1.5 and a price level of 1.0, a money wage level of 1.65 and a price level of 1.1, a money wage level of 3, 0 and a price level of 2.0, and so on.
Figure 22.4Natural employment and long-run aggregate supply
When the economy reaches its natural level of employment, as shown in Panel (a) at the intersection of the labor demand and supply curves, it reaches its potential output, as shown in Panel (b) by the labor curve. long run vertical aggregate supplyLRASnoYPAG.
In Panel (b) we see price levels ranging fromPAG1forPAG4. Higher price levels would require higher nominal wages to create a real wage of ωmi, and flexible nominal wages would achieve this in the long run.
In the long run, then, the economy can reach its natural level of employment and potential output at any price level. This conclusion gives us our long-run aggregate supply curve. With only one level of output at any given price level, the long-run aggregate supply curve is a vertical line at the economy's potential level of output.YPAG.
Equilibrium levels of prices and production in the long run
The intersection of the economy's aggregate demand curve and the long-run aggregate supply curve determines its equilibrium real GDP and long-run price level.Figure 22.5 "Long-term equilibrium"represents an economy in equilibrium in the long run. With aggregate demand inADVERTS1and the long-run aggregate supply curve, as shown, real GDP is $12 billion per year and the price level is 1.14. If aggregate demand increases toADVERTS2, the long-run equilibrium will be restored with a real GDP of US$12 trillion per year, but with a price level above 1.18. If aggregate demand falls toADVERTS3, the long-run equilibrium will still be at real GDP of $12 billion per year, but with the price level now lower than 1.10.
Figure 22.5long term balance
The long-run equilibrium occurs at the intersection of the aggregate demand curve and the aggregate supply curve in the long run. For the three aggregate demand curves shown, long-run equilibrium occurs at three different price levels, but always at a level of output of $12 trillion per year, which corresponds to potential output.
the short term
Analysis of short-run macroeconomics, a period in which wage and price stickiness can prevent the economy from operating at potential output, helps explain how deviations of real GDP from output can and do occur. potential. We will explore the effects of changes in aggregate demand and aggregate supply in the short run in this section.
Short Term Aggregate Supply
Figure 22.6Derivation of the short run aggregate supply curve
The economy shown here is in long-run equilibrium at the intersection ofADVERTS1with the long-run aggregate supply curve. If aggregate demand increases toADVERTS2, in the short run, both real GDP and the price level increase. If aggregate demand falls toADVERTS3In the short run, both real GDP and the price level fall. A line drawn through points A, B, and C traces the short-run aggregate supply curve.SARS.
The long-run aggregate demand and aggregate supply model predicts that the economy will eventually move toward its potential output. To see how nominal wages and price stickiness can keep real GDP above or below potential in the short run, consider the economy's response to a change in aggregate demand.Figure 22.6 "Deduction of the short-run aggregate supply curve"It shows an economy that has been operating with a potential output of $12 trillion and a price level of 1.14. This occurs at the intersection ofADVERTS1with the long-run aggregate supply curve at point B. Now suppose that the aggregate demand curve shifts to the right (aADVERTS2). This can occur as a result of an increase in exports. (The change ofADVERTS1forADVERTS2includes the multiplier effect of increased exports). At the 1.14 price level, there is now excess demand and pressure for prices to rise. If all prices in the economy were to adjust quickly, the economy would quickly settle on a potential output of $12 billion, but at a higher price level (1.18 in this case).
Is it possible to expand production beyond potential? Yes. It may be the case, for example, that some people who were in the labor force but were unemployed through attrition or structurally found work due to the ease of finding work at current nominal wages in such an environment. The result is an economy that operates at point A atFigure 22.6 "Deduction of the short-run aggregate supply curve"at a higher price level and with production temporarily above potential.
Consider next the effect of a reduction in aggregate demand (forADVERTS3), possibly due to reduced investment. As the price level begins to fall, so does output. The economy is in a price level and output combination where real GDP is below potential at point C. Again, price stickiness is to blame. The prices that businesses receive are falling with reduced demand. Without corresponding reductions in nominal wages, there will be an increase in real wages. Firms will employ less labor and produce less.
By examining what happens when aggregate demand changes during a period in which price adjustment is incomplete, we can plot the short-run aggregate supply curve by drawing a line through points A, B, and C.short run aggregate supply curve (SARS)Graphic representation of the relationship between production and the price level in the short term.It is a graphical representation of the relationship between output and the price level in the short run. Among the factors that remain constant in the design of a short-run aggregate supply curve are the stock of capital, the stock of natural resources, the level of technology, and the prices of the factors of production.
A change in the price level produces achange in the aggregate quantity of goods and services providedMovement along the short-run aggregate supply curve.and is illustrated by the movement along the short-run aggregate supply curve. This occurs between points A, B, and C onFigure 22.6 "Deduction of the short-run aggregate supply curve".
A change in the quantity of goods and services supplied at each price level in the short run is achange in aggregate supply in the short runA change in the aggregate quantity of goods and services supplied at each price level in the short run.. Changes in factors that are held constant in the design of the short-run aggregate supply curve shift the curve. (These factors can also shift the aggregate supply curve in the long run; we will discuss them along with other determinants of aggregate supply in the long run in the next chapter.)
One type of event that would shift the aggregate supply curve in the short run is an increase in the price of a natural resource such as oil. An increase in the price of natural resources or any other factor of production, other things being equal, raises the cost of production and leads to a reduction in aggregate supply in the short run. In Panel (a) ofFigure 22.7 "Short-term changes in aggregate supply",SARS1shift left toSARS2. A decrease in the price of a natural resource would reduce the cost of production and, otherwise unchanged, would allow more production from the economy's stock of resources and shift the short-run aggregate supply curve to the right; such a change is shown in Panel (b) by a change ofSARS1forSARS3.
Figure 22.7Short-run changes in aggregate supply
A reduction in aggregate supply in the short run shifts the curveSARS1forSARS2in panel (a). An increase moves it to the right toSARS3, as shown in Panel (b).
Reasons for price and wage stickiness
Wage or price stickiness means that the economy may not always be operating at its potential. Instead, the economy may operate above or below potential output in the short run. Consequently, the general unemployment rate will be below or above the natural level.
Many prices observed throughout the economy adjust rapidly to changes in market conditions, so that equilibrium, once lost, is quickly restored. Fresh food prices and common stocks are two examples.
Other prices, however, adjust more slowly. Nominal wages, the price of labor, adjust very slowly. We will first look at why nominal wages are sticky, due to their association with the unemployment rate, a variable of great interest in macroeconomics, and then at other prices that can be sticky.
Wage contracts set nominal wages for the duration of the contract. The duration of the salary contracts ranges from one week or one month for temporary staff, one year (teachers and professors usually have temporary contracts) and three years (for most unionized workers employed under the main agreements collective). The existence of such explicit contracts implies that both workers and companies agree to some salary at the time of negotiation, although economic conditions may change while the agreement is in force.
Think about your own job or a job you once had. Chances are, you go to work every day knowing what your salary will be. Your salary does not fluctuate overnight with changes in supply or demand. You may have a formal contract with your employer that specifies what your salary will be for a certain period of time. Or you may have an informal understanding that defines your salary. Whatever the nature of your contract, your salary is "locked in" for the duration of the contract. Your salary is an example of a fixed price.
One of the reasons that workers and companies may be willing to accept long-term nominal wage contracts is that negotiating a contract is an expensive process. Both parties must keep themselves adequately informed about market conditions. When unions are involved, wage negotiations raise the possibility of a labor strike, an eventuality for which companies can prepare by hoarding additional inventory, also a costly process. Even when unions are not involved, the time and energy spent discussing wages dwarfs the time and energy spent producing goods and services. Furthermore, workers may simply prefer to know that their nominal wage will be fixed for a period of time.
Some contracts attempt to account for changing economic conditions, such as inflation, through cost-of-living adjustments, but even these relatively simple contingencies are not as widespread as one might think. One reason might be that a firm is concerned that as the aggregate price level rises, the prices of the goods and services it sells may not move at the same rate. Additionally, cost of living or other contingencies add complexity to contracts that both parties may want to avoid.
Even markets where workers are not employed under explicit contracts seem to behave as if such contracts exist. In these cases, wage rigidity may result from a desire to avoid the same uncertainty and adjustment costs that explicit contracts avoid.
Finally, minimum wage laws prevent wages from falling below the legal minimum, even though unemployment is rising. Unskilled workers are particularly vulnerable to changes in aggregate demand.
The stickiness of other prices becomes easier to explain in light of the arguments about the stickiness of money wages. Since wages are a major component of the total cost of doing business, sticky wages can lead to sticky output prices. With stable nominal wages, at least some companies can adopt a "wait and see" attitude before adjusting their prices. During that time, can they evaluate information about why sales are increasing or decreasing (is the change in demand temporary or permanent?) get irritated by a price increase, for example? Will competing firms keep up with price changes?).
Meanwhile, companies may prefer to adjust output and employment in response to changing market conditions, product price aside. Quantity adjustments have costs, but companies may assume that the associated risks are less than those associated with price adjustments.
Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices. In some cases, companies must print new price lists and catalogs and notify customers of price changes. Doing this too often can damage customer relationships.
Yet another explanation for sticky prices is that firms may have explicit long-term contracts to sell their products to other firms at specified prices. For example, energy companies often purchase their coal or oil inputs through long-term contracts.
Taken together, these reasons for price and wage stickiness explain why aggregate price adjustment may be incomplete, in the sense that the change in the price level is insufficient to maintain real GDP at its potential level. These reasons do not lead to the conclusion that price adjustments do not occur. But adjustments take some time. During this period, the economy may remain above or below its potential level of output.
Equilibrium levels of prices and production in the short term
To illustrate how we will use the aggregate demand and aggregate supply model, let's examine the impact of two events: an increase in the cost of health care and an increase in government purchases. The first reduces the short-term aggregate supply; the second increases aggregate demand. Both events alter equilibrium real GDP and the price level in the short run.
A change in the cost of health care
In the United States, most people receive health insurance for themselves and their families through their employers. In fact, it's quite common for employers to pay a large percentage of employees' health insurance premiums, and this benefit is often included in employment contracts. As the cost of health care has increased over time, companies have had to pay higher and higher health insurance premiums. With short-term fixed nominal wages, an increase in health insurance premiums paid by companies increases the cost of employing each worker. It affects the cost of production in the same way as higher wages. The result of higher health insurance premiums is that companies will choose to employ fewer workers.
Suppose the economy initially operates in short-run equilibrium at the intersection ofADVERTS1miSARS1, with a real GDP ofY1and a price level ofPAG1, as it is shown inFigure 22.8 "An increase in health insurance premiums paid by companies". This is the initial equilibrium price and short-run output. The increase in the cost of labor shifts the short-run aggregate supply curve toSARS2. The price level rises toPAG2and real GDP falls toY2.
Figure 22.8An increase in health insurance premiums paid by companies
An increase in health insurance premiums paid by firms increases labor costs by reducing the short-run aggregate supply ofSARS1forSARS2. The price level rises fromPAG1forPAG2and production fallsY1forY2.
A reduction in health insurance premiums would have the opposite effect. There would be a shift to the right in the short-term aggregate supply curve, with pressures for a fall in price levels and an increase in real GDP.
A shift in government purchases
Suppose the federal government increases its spending on highway construction. This circumstance leads to an increase in US government purchases and an increase in aggregate demand.
Assuming that no other changes affect aggregate demand, the increase in government purchases shifts the aggregate demand curve by an amount times the initial increase in government purchases toADVERTS2noFigure 22.9 "An increase in government purchases". Real GDP rises fromY1forY2, while the price level rises fromPAG1forPAG2. Note that the increase in real GDP is less than it would have been if the price level had not increased.
Figure 22.9An increase in government purchases
An increase in government purchases boosts aggregate demand forADVERTS1forADVERTS2. The short-run equilibrium is at the intersection ofADVERTS2and the short run aggregate supply curveSARS1. The price level rises toPAG2and real GDP increases toY2.
On the other hand, a reduction in government purchases would reduce aggregate demand. The aggregate demand curve shifts to the left, pushing down both the price level and real GDP.
In the short run, real GDP and the price level are determined by the intersection of the short-run aggregate demand and aggregate supply curves. Remember, however, that the short run is a period in which sticky prices may prevent the economy from reaching its natural level of potential employment and output. In the next section, we will see how the model fits to bring the economy to equilibrium in the long run and what can be done to bring the economy back to its natural level of potential employment and output.
- The short run in macroeconomics is a period in which wages and some other prices are sticky. The long run is a period in which full wage and price flexibility and market adjustment have been achieved, such that the economy is at its natural level of potential employment and output.
- The long-run aggregate supply curve is a vertical line at the potential level of output. The intersection of the economy's long-run aggregate demand and aggregate supply curves determines its equilibrium real GDP and long-run price level.
- The short-run aggregate supply curve is an upward-sloping curve that shows the amount of total output that will be produced at each price level in the short run. The stickiness of wages and prices is responsible for the upward slope of the aggregate supply curve in the short run.
- Changes in the prices of the factors of production shift the aggregate supply curve in the short run. In addition, changes in the stock of capital, the stock of natural resources, and the level of technology can also cause the short-run aggregate supply curve to shift.
- In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the short-run aggregate demand and aggregate supply curves. In the short term, production may be below or above potential production.
The tools we discuss in this section can be used to understand the Great Depression of the 1930s. We know that investment and consumption began to decline in late 1929. The declines were reinforced by declining net exports and exports. government purchases in the next four years. In addition, nominal wages fell 26% between 1929 and 1933. We also know that real GDP in 1933 was 30% below real GDP in 1929. Use the short-run aggregate demand and aggregate supply tools to graph and explain what happened to the economy between 1929 and 1933.
Case in Point: The 2001 US Recession
What were the causes of the US recession of 2001? Economist Kevin Kliesen of the Federal Reserve Bank of St. Louis points to four factors that together shifted the aggregate demand curve to the left and kept it there long enough for real GDP to keep falling for about nine months. They were falling stock market prices, declining business investment in both computers and software and structures, declining real value of exports, and the aftermath of 9/11. Notable exceptions to this list of culprits were consumer spending behavior during the period and new residential homes, which fall under the investment category.
During the boom of the late 1990s, a rising stock market likely made it easier for companies to raise funds for infrastructure and information technology investments. Although the stock market bubble had burst long before the recession itself, the continuation of projects already underway delayed the fall in the investment component of GDP. In addition, IT spending is likely to continue as businesses were facing Y2K computer issues, i.e. computer problems associated with the date change from 1999 to 2000. Most computers used just two digits to indicate the date, the year and when the year changed. from 99 to 2000, the computers did not know how to interpret the change and extensive reprogramming of the computers was required.
Real exports fell during the recession because (1) the dollar was strong during the period and (2) real GDP growth in the rest of the world fell by almost 5% between 2000 and 2001.
Thus, the terrorist attacks of September 11, which literally brought transportation and financial markets to a standstill for several days, may have prolonged these negative trends long enough to turn what might otherwise have been a mild decline into a hub. enough city to qualify the period. like a recession.
During this period, the measured price level was essentially stable, and the implicit price deflator increased by less than 1%. Thus, while the aggregate demand curve has shifted to the left as a result of all the reasons outlined above, there has also been a leftward shift in the short-run aggregate supply curve.
Fuente: Kevin L. Kliesen, "The 2001 Recession: How Was It Different, and What Developments May Have Caused It?",Federal Reserve Bank of St. Louis Review, September/October 2003, 23–37.
Reply to test! Problem
All components of aggregate demand (consumption, investment, government purchases, and net exports) declined between 1929 and 1933. Thus, the aggregate demand curve shifted sharply to the left, fromADVERTS1929forADVERTS1933. The reduction in nominal wages corresponds to an increase in the short-term aggregate supply ofSARS1929forSARS1933. Since real GDP in 1933 was less than real GDP in 1929, we know that the movement of the aggregate demand curve was greater than the movement of the aggregate supply curve in the short run.
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Example of Long term goals Answer
I want to bring more than what is predictable of me. As for the long term goal, I look for bigger targets so that I can incessantly test myself. I need to figure myself during these preliminary years so that when the superior targets are put, I can carry the best outcomes.
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For example, you may want to clean out your closet, read that book that's been collecting dust on your nightstand, save the money you need to go on a long-overdue vacation, or finally run a 10K.What are my long-term goals examples? ›
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A short-term goal is any goal you can achieve in 12 months or less. Some examples of short-term goals: reading two books every month, quitting smoking, exercising two times a week, developing a morning routine, etc.What are 5 long term goals you have? ›
15 examples of long-term financial goals
Set aside money for your child's education. Boost your credit score. Pay off your mortgage. Create an investment plan.
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There are no exact definitions, but short-term usually means a period shorter than two years, medium-term covers a range from 2 to 5 or 10 years and long-term is a period longer than 5 or 10 years.How do you answer short-term employment? ›
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For example, if your long-term goal is to run a marathon and complete it within 4 hours, your short-term goals might include doing leg stretches for 10 minutes every morning before running and going on 5 mile runs twice per week.What are short-term and long-term goals examples for business? ›
An example of a short-term goal is to increase your advertising budget each month for the next three months. An example of a long-term business goal that the short-term goal helps achieve is to double business revenue by the end of the fiscal year.What is short-term and long-term employment? ›
What Exactly Is Short-Term Employment, And How Does One Get One? Jobs with a specific end date are called “short-term.” Full-time or part-time work may be considered short-term as long as they have an end date that is clear to both the employer and the employee.What does short-term mean in work? ›
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Unemployment is typically considered to be short-term. People looking for employment can apply their skills, experience, and knowledge obtained through education from one job to another. A fair number of unemployed workers are quick to get new jobs entering the employed category.