1st Session Wk13: AD-AS in the Long Run

Back to Chapter 20:

Long Run AD-AS modelling
 Modeling AD-AS in the Long Run
• We originally looked at AD-AS “in the short run”. We now have added
enough mainstream concepts of Economic Growth and the Long Run to go
back and add the mainstream model of Aggregate Supply in the Long Run
• This is based on is the idea of a long run natural rate of output, associated
with the natural rate of unemployment
• When we studied unemployment, I mentioned that the textbook definition
of cyclical unemployment is based on the difference between the natural
rate of unemployment and the actual rate of unemployment:
• Cyclical URate = Actual URate - Natural Urate
• Rearranging this, this means that the Actual unemployment rate can be
split up into the Natural Rate of Unemployment (which will be positive,
and the Cyclical Rate of Unemployment (which may be positive or
negative)
• Actual URate = Natural Urate + Cyclical URate
 Determinants of Natural Rate of Unemployment
• Actual URate = Natural Urate + Cyclical URate
• This implies that the cyclical unemployment is determined by something
other than the things that determine the natural rate of unemployment.
• In the mainstream system, the Natural Rate of Unemployment is
determined by Labor Force and the Natural Rate of Output, where the
natural rate of output is determined by:
 Available Resources
 Technology in Use
 Consumer preferences {though we do not focus in this determinant}
• There will be a certain number of workers required to produce the natural
rate of output, and the quality or quantity of available resources per
worker and the technical knowledge that determines technology in use, are
the same as the determinants of productivity that we looked at in Ch. 12.
• So the natural rate of unemployment is decided by the same things that
determine long run growth of aggregate supply in the economy.
 Determinant of Cyclical Unemployment
• So, what determines Cyclical Unemployment? It has to be something else
… but what?
• If we have exhausted the “real” factors that determine unemployment one
other place to look are “nominal” factors.
• After all, labor contracts are normally not specified in terms of real wages.
They are normally specified in terms of nominal wages – a promise of
payment in the standard of deferred payment.
• Now, suppose that the inflation rates that people expected when they
agreed to a labor contract are not the inflation rates they actually
experience.
• If the actual inflation rate is greater than the expected one, a wage offer in
terms of money will look better than it really is. So it will lead to more
willingness to work. That will make it easier to produce than it would be
if expectations matched actual inflation rates
• This means that production will be greater and unemployment rates lower.
• And visa versa.
 A simple model of Cyclical Unemployment
 So, in other words, if there is a “natural rate” of economic activity, Then
the actual unemployment rate can be thought of as determined by the
difference between Expected and Actual Inflation.
 In the simplest possible model, the difference between actual and
expected inflation can be multiplied by a conversion factor to predict the
cyclical unemployment, which will be positive if actual inflation is below
expectations, and negative if actual inflation is above expectations:
 Cyclical URate = – a×(Actual Inflation – Expected Inflation)
 So Actual URate = Natural URate – a×(Actual Inflation–Expected
Inflation)
 HOWEVER: As people EXPERIENCE the Actual Inflation Rate, their
Expected Inflation Rate moves in that direction … until the “gap” goes
away.
 So under this model, government can only TEMPORARILY push down
the URate, but at the cost of a PERMANENT increase in the expected
inflation rate.
 AD-AS in the Long Run

• So in this model, if changes in Aggregate Demand results in a rate of

unemployment different from the natural rate, there will be a
mismatch between inflation experience and inflationary expectations
• As expectations adjust, the Short Run AS curve (SRAS) will shift to
push the short run equilibrium toward the long run natural rate of
output … and continue shifting until .
• This gives a vertical Long Run Aggregate Supply “curve” (LRAS).
 Long Run AD-AS model
P
LRAS
AD AS

P0

Real GDP
Q0
Q* = Natural rate of output
Active Fiscal Policy with LRAS (short run)
P
AD1 LRAS
AD AS

P1

P0

Q0 Real GDP
Q1
Q* = Natural rate of output
Active Fiscal Policy with LRAS (long run)
P
AD1 LRAS AS2
AD AS
P2

P1

P0

Real GDP
Q2 = Q0 Q1
Q* = Natural rate of output
 Active Fiscal Policy with LRAS,
originally depressed conditions （ short run)
P
LRAS
AS

P1=P2

P0
AD1

AD
Real GDP
Q0 Q1
Q* = Natural rate of output
 Active Fiscal Policy with LRAS,
originally depressed conditions （ long run
P
(=SR))
LRAS
AS=AS2

P1=P2

P0
AD1

AD
Real GDP
Q0 Q1=Q2
Q* = Natural rate of output
 No Active Fiscal Policy with LRAS,
originally depressed conditions (short run)
P
LRAS
AS

P0=P1
AD1

AD=AD1
Real GDP
Q0=Q1
Q* = Natural rate of output
 No Active Fiscal Policy with LRAS,
originally depressed conditions (long run)
P
LRAS
AS
AS2

P0=P1
P2

AD=AD1
Real GDP
Q0=Q1 Q2
Q* = Natural rate of output
Positive LRAS shock (short run)
P LRAS1
AD1 LRAS
AD AS AS1

P0
P1

Real GDP
Q0 Q1
Positive LRAS shock (long run)
P LRAS1
AD1 LRAS
AD AS AS1
AS2

P0
P1
P2

Real GDP
Q0 Q1 Q2
 Class Exercise 1

• Form your permanent semester working groups of three to four

students, and discuss the following question.
• The economy is operating at or near "full employment", which means
unemployment is substantially below the estimated natural rate of
unemployment, and it is experiencing substantial inflation.
• (A) Model this position using the LRAS model (remember that output
is above the natural rate of output, so the AD-SRAS equilibrium
should not start at the three-way Long Run Equilibrium position).
• (B) Give an example of an Active Fiscal Policy for this problem.
• (C) Use the LRAS Model to show the the Short Run and Long Run
effects of this policy, including P1 & Q1 and P2 and Q2.
• Report your conclusions to class.