USC ECON 205 - Aggregate Demand and Aggregate Supply

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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 20Current LectureShort Run Aggregate Supply- SRAS curve is upward slopingo Increase in P causes an increase in quantity of g&s supplied- If AS slopes up, shifts in AD affect output and employmentThree 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 Theoryo Nominal wages are sticky in the short run, they adjust sluggishly Due to labor contracts, social normso Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevailo 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 Theoryo Many prices are sticky in the short-run Due to menu costso Firms set sticky prices in advance based on PEo Suppose the Fed increases the money supply unexpectedly In long run, P will riseo In short run, firms without menu costs can raise their prices immediatelyo Firms with menu costs wait to raise prices While their prices are lower, increasing demand for their products, so they increase output and employmento Hence, higher P is associated with higher Y, so SRAS curve slopes upward- The Misperceptions Theoryo Firms may confuse changes in P with changes in the relative price of the productsthey sello If P rises above PE, a firm sees its price rise before realizing all prices are risingo The firm may believe its relative price is rising, and may increase output and employmento So an increase in P can cause an increase in Y, making the SRAS curve upward-sloping- In all theories, Y deviates from YN when P deviates from PEo Y = YN + a(P – PE)SRAS and LRAS- The imperfections in these theories are temporaryo Sticky wages and prices become flexible over timeo Misperceptions are corrected over time- In LR,o PE = P, so Y = YNo AS curve is verticalWhy the SRAS Curve Might Shif- Everything that shifts LRAS shifts SRAS too- PE shifts SRASLong-Run Equilibrium- PE = P- Y = YN- Unemployment is at its natural rateEconomic Fluctuations- Caused by events that shift the AD and/or AS curves- 4 steps to analyzing economic fluctuations1. Determine whether the event shifts AD or AS2. Determine whether the curve shifts right or left3. USE AD-AS diagram to see how the shift changes Y and P in the short run4. Use AD-AS diagram to see how economy moves from new SR equilibrium to new LR

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