Post on 27-Dec-2015
Aggregate Supply
Frederick University
2014
Long Run vs. Short Run from a Macroeconomic Perspective
Long run period in macroeconomics the changes in the prices of
production factors and in the prices of final goods and services are entirely synchronized
Short run in macroeconomics the changes in the prices are not
synchronized
Aggregate Supply (AS)
AS – the willingness and ability of firms to produce GDP at every price level, ceteris paribus
Deriving AS - short run
PPF and Potential GDP
А
В
Physical PPF
Institutional PPF
U
1. The economy is in point U – high unemployment
And excess capacity – low AD. The firms wouldIncrease production at the current price level(they do not need to be motivated by a price
increase) V
2. The economy moves to point V – due to the law of diminishing returns МС start rising. The firms would increase production if only their buyers are willing to compensate them for the cost increase. Since АС grow more slowly than МС (short run and fixed cost), the increase in production is faster than the increase in the price level, i.е. production will increase faster than the price level until it gets to point W
W
Deriving AS - short run Potential GDP and AS
Physical PPF
Institutional PPF
U
V
CPI
Real GDP
U V
W
W
At point W the economy operates at full capacity, MRPL = MCL; any further increase in production will be accompanied by a faster increase in cost. The firms would increase production if only their buyers are willing to compensate them for the cost increase – the price level will rise faster than output – the economy will move from point W to point Z
Z
Z
AS
AS Analysis – short runAS segments in the short run:1. Horizontal Е = ∞ - from U to V – the firms are willing
to increase production at the current price level; the economy operates at excess capacity
2. Shallow Е > from V to W – output rises faster than the price level
3. E = 1 – point W – the economy operates at full capacity on the Institutional PPF and produces potential GDP; the rate of unemployment is equal to the natural rate
4. Steep E < 1 – from W to Z – the economy operates at overcapacity – prices increase faster than output
5. Vertical Е = 0 – from Z – firms cannot increase output whatever the price level is. The economic activity is on its physical PPF
AS analysis – short run
Slope of the AS curve in the short run – determined by the law of diminishing returns and the price adjustment to cost increase
Short run – the macroeconomic perspective – the period, during which, the changes in the prices final goods and services and in the prices of production factors are not synchronized.
Factors, determining AS - short run
Cost of production: Labor cost – depends on education, traditions
(attitude to work and leisure), labor supply, competitiveness of the market structure, expectations, productivity
Capital cost – depends on the savings and investment structure, raw material supplies, technological changes, competitiveness of capital markets
Government policies – regulations, taxation, social programs
Foreign sector – barriers to international trade, structure of the balance of payments
Macroeconomic Equilibrium – short run
CPI
Real GDP
ADAS
Y*
AD1
Y1
Y1 – Y* = inflationary gap
AD2
Y2
Y* - Y2 = recessionary gap
Potential GDP and AS – long run
Potential GDP (Y*) – the level of output, which could be achieved given the physical and institutional constraints of the economic activity (full employment GDP)
Full employment – the employment level, determined by the potential output
Natural rate of unemployment (U*) – the rate of unemployment at the potential GDP level.
Potential GDP and AS – long run
CPI
Real GDPY*
LRAS
Long run – the increase in the overall pricelevel and in the prices of productionFactors are entirely synchronized.In the long run, the increase in the prices of final goods and services does not motivate the firms to increase output, since their costwould increase at the same rate.
Potential GDP and AS – long run
Factors, determining AS in the long run: Labor resources – quantity and quality,
productivity, education, traditions, motivation, demographic factors
Capital resources – quantity and quality, rate of capital accumulation
Technological changes Institutional changes
Macroeconomic equilibrium in the long run
CPI
Real GDP
ASAD