Short-run and Long-run

 In macroeconomics, the short run is generally defined as the

time horizon over which the wages and prices of other inputs
to production are "sticky," or inflexible,
 and the long run is defined as the period of time over which
these input prices have time to adjust.
 Aggregate supply

 Aggregate supply: The total supply of goods and services

produced within an economy at a given overall price level,
in a given time period.
 This is represented through an aggregate supply curve,
which shows the relationship between the price level and
quantity of output that firms are willing to supply.
 As with regular supply, the relationship between aggregate
supply and price is often a positive one, meaning that at a
higher price level firms are willing to produce more.
 One thing to note here though is that the shape and
behaviour of the aggregate supply curve is of debate
amongst economists.
 i. under theories of neo-classical economists,
 ii. the view of Keynesians (named after the seminal
economist John Maynard Keynes).
 Short Run Aggregate Supply (SRAS)

In the short run, the aggregate supply curve slopes upwards, as a regular
supply curve does.
 Shifts in the SRAS curve

 The shift from SRAS1 to SRAS2 shows an increase in aggregate supply at

each price level

 The shift from SRAS1 to SRAS3 shows a decrease in aggregate supply at

each price level
What causes the shift forwards or backwards
in short run aggregate supply?

 Change in factor productivity of both labour and capital

 Change in size and quality of capital stock, through investment

 Change in size and quality of the labour force

 Change in unit cost of labour (i.e. wages)

 Change in producer taxes or subsidies

 Change in inflationary expectations (e.g. causing a rise in inflation, and a

rise in wages, causing supply to shift inwards)
 Long Run Aggregate Supply (LRAS)

 In the short run, supply changes to the price level, as the factors of production are
adjusted to enable the most efficient use of resources.

 In the long run however, it is assumed that supply stays independent of the price
level. It is determined by the overall productivity of the resources in the economy.

 Another way of viewing this is that LRAS represents the productive potential of the
economy. If all resources were at their most productive; that is the level of output that
could be achieved.

 Shifts in LRAS are therefore factors that affect the level of this potential.
 Because it is independent of the price level, and signifies the upper limit of the
capacity in the economy, the curve is a vertical line.
Long Run Aggregate Supply (LRAS)
Shifts in Long Run Aggregate Supply (LRAS)

 By its nature, it is assumed that the LRAS curve doesn’t fluctuate too greatly. Instead,
if there are significant, permanent changes to the productive potential of the
economy, then this will lead to a shift.

 An increase in quantity and productivity of the factors of production, or an

advancement in technology in the economy would cause an increase in the
productive potential.

 This is shown as the shift outward of the LRAS curve.

By its nature, it is assumed that the LRAS curve doesn’t fluctuate too greatly. Instead,
if there are significant, permanent changes to the productive potential of the
economy, then this will lead to a shift.
 Aggregate demand

 Aggregate demand: The total amount of goods and services demanded within
an economy at a given overall price level, and in a given time period.

 This is represented through an aggregate demand curve, which shows the

relationship between the price level and quantity of output that agents are
willing to spend.

 As with regular demand, the relationship between aggregate demand and

price is often a negative one, meaning that at a higher price level households
are willing to consume less.
 Components of aggregate demand
 The factors that make up AD will be recognisable from earlier sections in this
chapter on GDP. The reason for the similarity is that AD is a measure of all that is
demanded within an economy, and so is equivalent to the expenditure amount.

 it is made up of:
• C: consumer expenditure on goods and services
• I: Investment spending

• G: Government spending
• (X-M): the net difference between exports and imports in the economy.
Shifts in the AD curve
 Shifts in the AD curve

 Some reasons for this shift in aggregate demand will be due to a

change in any of the component parts of the equation. The
following would cause a shift out of the AD curve:
 • Consumers have more income and begin spending more in the
economy
 • Firms have a wave of optimism and begin in investment in projects
 • Government decides to spend more on infrastructure projects
 • Exports become more attractive to foreign firms
 • Imports become less desirable for domestic firms
 Equilibrium of AS and AD

 using the neo-classical approach to aggregate supply, and the aggregate

demand
 The macroeconomy is in equilibrium at the point where SRAS (value of output
produced within an economy) is equal to AD (level of demand for goods and
services).

 The reason it is not the LRAS is that this is the productive potential in the economy.
SRAS is what is actually being supplied in the macroeconomy, and is therefore
what equilibrium should be based upon.

 If the general price level is above the equilibrium point, then firms will persistently
find that their stock levels are being unsold. This then indicates that they should cut
back on further production, to reduce the level of inventory.

 If, however, the general price level is below the equilibrium point, then demand
will outstrip supply, stocks will quickly become run down, thus signalling to
producers that they should increase supply.

 These mechanisms ensure that the macroeconomy is restored to equilibrium.

Changes in aggregate demand

 An increase in AD (shift in curve) causes an increase in AS (movement

along curve) leading to an
increased level of national output.

 In the process, this causes an

increase in the price level within the
economy.
Changes in short run aggregate supply

 An increase in AS leads to an
expansion along AD curve.

 Here, the rise in supply (perhaps

caused through a fall in production
costs) has led to aggregate
demand meeting it at a lower price
level, thus increasing national
output.
Changes in both AD and SRAS

 Suppose there has been a rise in the cost of imported raw materials.

 This leads to a decrease in the level

of AD and also decrease in SR AS
curve as the cost of production
increases for firms.

 As a result, equilibrium in the

economy shifts back to point C.
Changes in both AD and SRAS

 Suppose there has been a rise in AD, causing an increase in government

spending and also a decrease in the
short run aggregate supply (caused
by a rise in wage costs).
 The rise in AD leads equilibrium from A
to B and the rising wage costs shift the
SR AS curve back from C to A.
 These two effects, in this instance,
have cancelled each other out,
meaning that the equilibrium level of
output has been returned to Ya.
 Output Gap

 The difference between the actual output of an economy and the

production potential of an economy is known as the output gap.

 There can be both negative and positive output gaps.

 Negative gaps are when an economy is performing below its potential, and
positive gaps are when it is above its potential.
 Inflationary Gap

 Inflation: A continuous or persistent rise in general price level.

 inflationary gap: When the equilibrium in the macroeconomy is beyond the

productive potential, it is said that there is an inflationary gap.
 Deflationary Gap

 Deflation: A continuous or persistent decrease in general price level.

 Deflationary gap: the deflationary (or recessionary) gap exists when the equilibrium in
the economy is less than the production potential.