ECON 205 2nd Edition Lecture 21 Outline of Last Lecture I The Laffer Curve and Government Spending II The Three Types of Budgets III Aggregate Measures Supply and Demand and the GDP IV Social Overhead and the Life Cycle Model Outline of Current Lecture I Aggregate Supply Short and Long Term II Determinants of Aggregate Supply III Sticky Wages and Prices IV Unemployment Costs V Inflexibility and Menu Costs Current Lecture I Aggregate Supply Short and Long Term Aggregate supply describes the behavior of the production side of the economy The aggregate supply curve AS curve shows the level of total national output that will be produced at each price level ceteris paribus The short run aggregate supply schedule is inflexible for prices and wages leading to an upward sloping AS curve higher prices mean more production Over the long term however most elements of the business cycle are perfectly flexible and output is determined by potential output only It is a vertical line II Determinants of Aggregate Supply Potential output is the maximum sustainable output that can be produced without causing rising inflation The long term AS curve is determined by the same factors that cause economic growth namely quantity and quality of labor supply of capital and resources and technology level We measure the potential GDP at the unemployment rate NAIRU nonaccelerating inflation rate of unemployment An upward shift of the AS curve is caused by increases in costs of production while an outward shift is caused by increases in potential output Keynesian macroeconomics is associated with an upward sloping short run aggregate supply In it changes in aggregate demand have significant effects on output If aggregate demand falls due to monetary tightening or a falloff in spending this will lead to falling output and prices The long run approach called classical macroeconomics says that changes in aggregate demand change prices but not real output In the long term prices and wages adjust to AD The classical curve is vertical changes in AD have no effect on output III Sticky Wages and Prices Some elements of business costs are inflexible or sticky in the short run Because of that firms respond to higher demand by raising both production and prices However in the longer run costs respond fully and increased demand takes the form of higher prices In the long run therefore the curve is vertical IV Unemployment Costs Employed persons are people who perform any paid worked unemployed are persons that do not have a job have actively looked for work in the prior 4 weeks not in the labor force are the 34 of the adult population keeping house retired too ill to work or not looking for work and labor force is all employed and unemployed The unemployment rate is the number of unemployed divided by the total labor force High unemployment presents major problems creating economic losses in output psychological tolls of long periods of persistent involuntary unemployment and loss of selfworth Okun s Law relates unemployment to GDP stating that for every 2 percent that the GDP falls relative to potential GDP unemployment rate rises about 1 V Inflexibility and Menu Costs Most firms set pay scales and hire people at an entry level wage or salary which changes yearly Many economists believe that the inflexibility arises because of the costs of administering compensation menu costs Union wages negotiation is a long process that requires worker and employer time but produces no output Personnel managers therefore refer a system in which wages are argued infrequently and most workers in a firm get the same pay increase