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