EC 111 1st Edition Lecture 20PREVIOUS LECTUREI. IntroductionII. The Model of Aggregate Demand and Aggregate SupplyIII. Why Aggregate Demand Curve Slopes DownwardIV. The Wealth Effect (Price and Consumption)V. The Interest Rate Effect (Price and Investment)VI. The Exchange Rate Effect (Price and Net Exports)VII. The Slope of the Aggregated Demand Curve SumVIII. Why the Aggregated Demand Curve Might ShiftIX. The Aggregated Supply CurvesX. The Long-Run Aggregated Supply Curve (LRAS)XI. Why the Long-Run Aggregated Supply Curve is VerticalXII. Why the Long-Run Aggregated Supply Curve ShiftsXIII. Using the Aggregated Demand and Aggregated Supply to Depict Long Run GrowthCURRENT LECTUREI. Short-Run Aggregated Supply Curve (SRAS)II. Why the Slope of the Short-Run Aggregated Supply Curve MattersIII. Three Theories of the Short-Run Aggregated Supply CurveIV. 1. The Sticky Wage TheoryV. 2. The Sticky Price TheoryVI. 3. The Misperception TheoryVII. What the Three Theories Have in CommonVIII. Short-Run Aggregated Supply and Long-Run Aggregated SupplyIX. Why the Short-Run Aggregated Supply Curve Might ShiftX. The Long-Run EquilibriumXI. Economic Fluctuation SHORT-RUN AGGREGATED SUPPLY CURVE (SRAS)- The SRAS curve is upward sloping:o Over the period of 1-2 years, an increase in P causes an increase in the quantity of goods and services suppliedWHY THE SLOPE OF THE SHORT-RUN AGGREGATEDSUPPLY CURVE MATTERS- If aggregated supply is vertical fluctuations in aggregated demand do not cause fluctuations in output or employmentGradeBuddy- If aggregated supply slopes up, then shifts in aggregated demand DO affect output and employment- Output and employment are tied together in this modelo If output increases, then employment increasesTHE THREE THEORIES OF SHORT-RUN AGGREGATEDSUPPLY- In each:o There is some type of market imperfectiono Result: Output deviates from its natural rate when the actual price level deviates from the price level people expected#1 THE STICKY WAGE THEORY- Imperfection:o Nominal wages are sticky in the short-run, they adjust sluggishly Due to labor contracts and social normso Firms and workers set the nominal wage in advanced based on the price level they expect to prevail- If Price> and expected Price:o Revenue is higher, but labor cost is noto Production is more profitable, so firms increase output and employment- Hence price causes higher output, so the SRAS slopes upward#2 STICKY PRICE THEORY- Imperfection:o Many prices are sticky in he short-run Due to menu costs, the cost of adjusting priceso Firms set sticky prices in advanced based on expected priceo Suppose the Fed increases money supply unexpectedly. In the long-run price will rise In short-run firms without menu costs can raise prices immediately  Firms with menu costs wait to raise prices. In the mean time their prices say relatively low. Demand increases for these products so increase output and employees- Hence, price is associated with higher output, so SRAS curve slopes upward#3 MISPERCEPTIONS THEORY- Imperfection:GradeBuddyo Firms may confuse changes in price with changes in the relative price of the products they sello If price rises above the expected price, a firm sees its price increase before realizing prices are rising May believe relative price is increasing and may increase output and employment- So an increase in price can cause an increase in output, making the SRAS curve upward slopingWHAT THE THREE THEORIES HAVE IN COMMON- In all three theories, output deviates from the natural output when price deviates from the expected price- Natural rate of output of long-run aggregated supply curve (LRAS) is ALWAYSperfectly verticalTHE SHORT-RUN AGGREGATED SUPPLY AND LONG-RUNAGGREGATED SUPPLY- The imperfections in these theories are temporary. Overtime:o Sticky wages and prices become flexibleo Misperceptions are connected- In the long-runo Price equals the expected priceo Aggregated supply curve is verticalWHY THE SHORT-RUN AGGREGATED SUPPLY CURVEMIGHT SHIFT- Everything that shifts the LRAS shifts the SRAS too- Also, expected price shifts the SRAS- IF expected price rises, workers and firms set higher wages- At each price, production is less profitable, output falls and SRAS shifts leftTHE LONG-RUN EQUILIBRIUM- In long-run equilibriumo Price=expected priceo Output=natural outputo Unemployment is at its natural rate (does not mean 0)ECONOMIC FLUCTUATION- Stagflation: a period of falling output and rising