From the AS-AD model, we know that AD curve, SRAS curve, and LRAS curve must coincide at one point to attain long-run equilibrium. But the question is, how does that happen? There are two ways to move from short-run equilibrium to long-run equilibrium -- either on the demand side (AD, government intervention) or the supply side (SRAS, market force). We will focus on the market adjustment mechanism in the following discussion.
1. How short-run shocks to aggregate demand correct in the long run
In the long run, rising labour costs causes SRAS to decrease. This happens because expectations of further inflation and higher resource costs lead firms to produce less and charge higher prices. Output decreases and the price level increases. Output keeps falling and price level keeps rising until real GDP returns to full employment output. As long as output is higher than full employment output, an unemployment rate that is higher than the natural rate will put upward pressure on wages and prices. The long-run outcome is that real GDP returns to the full employment level of output and the unemployment rate is equal to the natural rate. The price level, however, is now permanently higher.
Suppose an increase in the price of oil leads to a negative supply shock (because an increase in input prices will cause SRAS to decrease). Here’s what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up. The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages). SRAS increases once wages have adjusted, because a decrease in the price of a input to production will lead to an increase in SRAS. Output returns to the full employment output.
If a supply shock is permanent, there is an entirely different impact. Suppose that there is a permanent negative supply shock that makes the entire economy less productive, such as stricter regulations on production. Here’s what will happen: The capacity of the economy has decreased, so LRAS shifts to the left. Because such regulations make the cost of production higher, SRAS will also decrease until output has returned to the full employment output. In this case, output is permanently lower and the price level permanently higher.
Hint: Understand the concept and apply it in the model
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Hint: Understand the concept and apply it in the model
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Hint: Understand the concept and apply it in the model
Related concepts: