Aggregate Demand and Aggregate Supply 4

Aggregate Demand and Aggregate Supply 4 - 4 Why the...

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Unformatted text preview: 4. Why the aggregate supply curve slopes upward in the short run In the short run, the quantity of output that firms supply can deviate from the natural level of output if the actual price level in the economy deviates from the expected price level. Several theories explain how this might happen. For example, the slickv-wage flleory asserts that output prices adjust more quickly to changes in the price level than wages do, in part because of long—term wage contracts. Suppose a firm signs a contract agreeing to pay its workers $15 per hour for the next year, based on an expected price level of 100.1fthe actual price level turns out to be 110, the firm's output prices will rise if , and the wages the firm pays its workers will remain fixed at the contracted level. The firm will respond to the unexpected increase in the price level by increasing V’ the quantity of output it supplies. If many firms face similarly rigid wage contracts, the unexpected increase in the price level causes the quantity of output supplied to rise above if the natural level of output in the short run. fiPoints:—1}1 Explanation: Close Explanation A According to the sticky—wage theory, the short—run aggregate supply curve slopes upward because nominal wages are slow to adjust to economic conditions. If the price level turns out to be higher than what firms and workers anticipated when they negotiated wage contracts, output prices will rise even as wages remain fixed at the agreed—upon level. As firms see their output prices rise faster than their input prices, their profits rise, which gives them an incentive to increase production. Conversely, if the price level is unexpectedly low, firms will see their output prices fall below expected levels with no change in their labor costs. They will respond by reducing output. l} Quantity of Output Supplied = Natural Levei of Output+ ax [Price Leyeikm, — Price Leyeigmmd} The Greek letter (1 represents a number that determines how much output responds to unexpected changes in the price level. In this case, assume that {I = $4 billion. That is, when the actual price level exceeds the expected price level by 1., the quantity of output supplied will exceed the natural level of output by $4 billion. Suppose the natural level of output is $40 billion of real GDP and that people expect a price level of 1.10. On the foiiowing graph, use the pumie iine (diamond symboi) to piot this economy's iong—mn aggregate suppiy (LRAS) curve. Then use the orange iine segments (square symboi) to piot the economy's short—run aggregate suppiy (AS) curve at each of the foiiowing prite ieveis: I 00, I 05, I I 0, 1 I 5, ant:r rm. 125 120 J 115 11‘1'.| o 195 LFU‘IS 100 PRICE LEVEL 8 a T5 D1D20304D5OEDTDEDQO1UG OUTPUT (Billiuns of ddlars) The short—run quantity ofoutput supplied by firms will fill below the natural level ofoutput when the actual price leve falls below 1’ he pn'oe level that people expected. ...
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