Short Run Aggregate Supply

1
Short Run Aggregate Supply
2
Long Run to Short Run

• What weve seen as the LRAS is the notion of
  aggregate supply in the classical model
• This aggregate supply curve has no room for
  business cycles
• Any variability in AD will not result in
  variability in output
• This is not realistic

3
Short Run

• While the LRAS represents the potential or
  natural output level, there is variation around
  this level over time
• This variation must be due to the inability of
  markets to clear instantaneously
• Why dont markets clear continuously?

4
Market Imperfections

• The reason that markets dont clear continuously
  has two components
• Wage stickiness
• Price Expectations
• The combination of the these two characteristics
  allow for AD variation to result in serially
  correlated movements in Y (Business Cycles)

5
Wage Stickiness

• Wage stickiness means that wages dont change
  instantaneously due to changes in the market for
  labor
• Many jobs are contractual the pay is set for a
  fixed time period
• Even jobs that dont have fixed contracts often
  only change wages a periodic intervals (annually)

6
Price Expectations

• When an employee and employer agree on a nominal
  wage, they each have a prediction or expectation
  of the price level
• The nominal wage and the expected price level
  combine to form an expected real wage
• Deviations from the expected price level will
  result in deviations from L and Y

7
Expansionary and Contractionary Gaps

• An expansionary gap occurs when AD is higher than
  expected
• This boost in AD puts upward pressure on prices
• A contractionary gap occurs when AD is lower than
  expected
• This reduction in AD puts downward pressure on
  prices

8
Short Run Adjustment

• Why doesnt the price change instantly and the
  economy move along the LRAS?
• It can be explained either of two ways
• Wage contracts (ie wage stickiness)
• Asymmetric information
• Either explanation results in the same
  qualitative conclusion

9
Labor Market

• Because of the wage contracts (or differences in
  information), changes in the price level lead to
  deviations in employment and output levels
• If there is an expansionary change in AD prices
  will start climbing this increases the value of
  the marginal product of labor (nominal demand for
  labor)

10
Labor Market

• Because workers are bound to work for the
  contractual wage, firms hire more labor
• When they hire more labor they make more stuff
• Consequently, the increase in AD has resulted in
  more output
• An upward sloping SRAS

11
Adjustment

• Of course, over time the wage contracts expire
  and wages are renegotiated
• As this process occurs the SRAS shifts back
  toward the LRAS
• How long does it take?
• It depends on who you ask

12
New Classicals vs. New Keynesians

• New Keynesians believe that the adjustment
  process can take a long time
• Therefore, there is a role for government
  stabilizing AD
• New Classicals believe adjustment takes a short
  amount of time
• They believe that activist policy is
  destabilizing