ECON 205 1st Edition Lecture 17 Outline of Last Lecture What are econ fluctuations How does the model of aggregate demand and aggregate supply explain fluctuations What determines shape of AD curve What shifts it Shape of AS curve in short run vs long run Outline of Current Lecture Continuation of chapter 20 Current Lecture Short Run Aggregate Supply SRAS curve is upward sloping o Increase in P causes an increase in quantity of g s supplied If AS slopes up shifts in AD affect output and employment Three Theories of SRAS Some type of market imperfection Output deviates from its natural rate when the actual price level deviates from the price level people expected Sticky Wage Theory o Nominal wages are sticky in the short run they adjust sluggishly Due to labor contracts social norms o Firms and workers set the nominal wage in advance based on PE the price level they expect to prevail o If P PE Revenue is higher but labor cost is not Production is more profitable so firms increase output and employment Hence higher P causes higher Y The SRAS curve slopes upward Sticky Price Theory o Many prices are sticky in the short run Due to menu costs o Firms set sticky prices in advance based on PE o Suppose the Fed increases the money supply unexpectedly In long run P will rise o In short run firms without menu costs can raise their prices immediately o Firms with menu costs wait to raise prices While their prices are lower increasing demand for their products so they increase output and employment o Hence higher P is associated with higher Y so SRAS curve slopes upward The Misperceptions Theory o Firms may confuse changes in P with changes in the relative price of the products they sell o If P rises above PE a firm sees its price rise before realizing all prices are rising o The firm may believe its relative price is rising and may increase output and employment o So an increase in P can cause an increase in Y making the SRAS curve upwardsloping In all theories Y deviates from YN when P deviates from PE o Y YN a P PE SRAS and LRAS The imperfections in these theories are temporary o Sticky wages and prices become flexible over time o Misperceptions are corrected over time In LR o PE P so Y YN o AS curve is vertical Why the SRAS Curve Might Shif Everything that shifts LRAS shifts SRAS too PE shifts SRAS Long Run Equilibrium PE P Y YN Unemployment is at its natural rate Economic Fluctuations Caused by events that shift the AD and or AS curves 4 steps to analyzing economic fluctuations 1 Determine whether the event shifts AD or AS 2 Determine whether the curve shifts right or left 3 USE AD AS diagram to see how the shift changes Y and P in the short run 4 Use AD AS diagram to see how economy moves from new SR equilibrium to new LR equilibrium