Quiz 18: Extending the Analysis of Aggregate Supply

Business

The figure of the question is reproduced below. img img In the short run, the economy moves along AS2. When price increases froM120 to 130, output increases from $870 to $890. In the long run, as price increases nominal wages adjust to a higher level and firms cut output back to the full-employment level of $870. Aggregate supply curve shifts leftward to AS3. In the short run, the economy moves along AS2. When price decreases froM120 to 110, output decreases from $870 to $850. In the long run, as price decreases nominal wages adjust to a lower level and firms increase output back to the full-employment level of $870. Aggregate supply curve shifts rightward to AS1. The long-run level of output is the full-employment level, which is $870.

The distinction of long run and short run in economics is important. In long run, the aggregate supply curve is vertical, meaning that the input price is flexible, while in the short run the aggregate supply curve is upward-sloping, meaning that the input price is sticky. The different supply curves lead to difference of long-run equilibrium and short-run equilibrium, which requires different economic policies.

The output level is calculated using the formula of supply schedule, which is given by: img Where " P " is the price level " a " is the vertical intercept " b " is the slope " Q " is the output level. On substitution:. img Thus, the real output level in dollar terms when P is $120 is $200. In the short run, economy moves along the supply curve. When price increases to 132, the new output level is calculated as follows: img Thus, when price increases to $132, the new real output level in dollar terms is $224. In the long run, output level will fall back to the full-employment level of $200. Since in the long run, nominal wages will adjust to a higher level, firms cut output back to the full-employment level.