Long run Aggregate Supply (completing the AD/AS model) introduction The concept of long-run aggregate supply (LAS) must be developed before we can understand how inflation and unemployment are determined by the economy. We will portray the notion of the LAS curve differently from the way Gottheil does in his text. In Gottheil's text the aggregate supply curve becomes vertical at the level of real GDP that defines full employment. From page 176 of Gottheil's Principles of Macroeconomics 3e:

I think it is better to conceive of the AS curve becoming vertical when the economy reaches its physical limit, not full employment. It is possible to produce output levels beyond full employment for some period of time. These high levels of real GDP cannot be maintained indefinitely, but can be reached. With Gottheil's conception, the economy can never produce beyond full employment -- the frictionally and structurally unemployed cannot be enticed to work for higher wages. The way we will develop our

Notes:

LAS will explain our full employment economy better than the manner in which Gottheil does. natural rate of unemployment recall: full employment -- a level o f output for which the number of jobs created equals the number of qualified persons available to fill the jobs. This is equilibrium in the labor market. People are frictionally and structurally unemployed. There is no cyclical unemployment. another wa y to state full employment is in terms of the rate of unemployment: natural rate of unemployment -- unemployment rate at which there is an approximate balance between the number of unfilled jobs and the the number of qualified job seekers. This is the unemployment rate associated with the full employment level of output. natural rate of unemployment is due to frictional and structural conditions of the labor market -- it is sustainable in the future -- it may be maintained. macroeconomic short-run and long-run macroeconomic short-run -- length of time for which only prices of goods and services change, but the prices of resources do not change Wages account for approximately 70% all costs. Hence, for our purposes, the short-run is the length of time for which wages are constant. Labor costs will be our focus macroeconomic long-run -- length of time sufficient for for prices of all resources to change The long-run is the length of time it takes for wages to change. summary: short-run -- wages fixed long-run -- wages completely flexible -- perfect wage and price flexibility

Notes:

short-run aggregate supply (AS) short-run aggregate supply -- the relationship between the aggregate quantity of goods and services produced (real GDP) and the price level when resource prices are held constant (wages) short-run aggregate supply curve -- plots the relationship between real GDP supplied and the price level holding wage rates constant

This is simply the intermediate or "normal" range of our AS curve we developed earlier when we discussed the three ranges of levels of employment when we were giving the basics of the AS curve. The curve has a positive slope because as firms attempt to increase the amount of product they produce (output if one considers products in aggregate ), they must offer higher wages to entice workers to their industry. This is the reason the curve has a positive slope, but for this graph wages are assumed to constant -- if wages change the AS curve will shift. long-run aggregate supply (LAS) long-run aggregate supply -- relationship between the aggregate quantity of goods and services (real GDP) and the price leve l when the level of output is full employment When a sufficient amount of time has passed for wages to adjust to changing labor market conditions -- the long-run will be attained long-run aggregate supply curve -- plots the relationship between real GDP and the price level when wages are completely flexible and hence full employment obtains

Notes:

Notes:

The LAS is vertical at the full employment level o f output. Wages have time to fully adjust and the changes in costs from the wage changes are passed on to consumers in the form of price changes. Gottheil's model has no contingency for the long run. To compare Gottheil's perspective (simplified some from ours - not completely inconsistent) to the model we will be adopting:

To compare Gottheil's model with ours:

Notes:

types of macroeconomic equilibrium There are three basic types of macroeconomics equilibrium. Macroeconomic equilibrium is judged according to the relationship of the equilibrium level of output to the long run aggregate supply curve (which is located at the full employment level of real GDP). The animated diagram below explains the three types of equilibrium. It also shows the relationship of our AD-AS model to the business cycle. You can trace the business cycle for the United States economy and illustrate what was happening in the economy at any specific point in time with the AD-AS model. It "seems" to run slow.

Notes:

automatic adjustment process If the equilibrium level of real GDP is exactly equal to the full employment level of real GDP, a long run equilibrium has obtained. There is no tendency for change. In the model, ceteris paribus, the equilibrium would remain for all eternity! The economy would never expand or contract. Of course, that world is only the world of the ADAS model. In the real world something always changes. If the equilibrium level of real GDP is not equal to the full employment level of real GDP, the equilibrium level of real GDP will change automatically! Real GDP will adjust toward the long run equilibrium without any discretionary action by the Federal Reserve or the federal government. This is a big deal.

Notes:

preview of AD-AS A common example of the AD-AS model is an increase in AD. The model will need to be "fleshed out" over the next couple of weeks, but be the end of the quarter you will be able to understand and conduct an analysis similar to the following example.