Determinates o same as long run plus o wageprice

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Determinates: o Same as long run PLUS o Wage/price rigidity Embedded inflation expectations in labor/other contracts and these price level/inflation expectations do not equal actual price level/inflation Sometimes costly for businesses to change prices – “sticky” wages/prices result in inflation or deflation impacting output and employment in short run o Economic shocks – cause fluctuations around a nation’s potential output through price effects Negative AS supply shock (i.e. unexpected increase in oil prices) reduces real GDP and increases price level (stagflation) Theories that explain why SRAS slopes upward o Sticky wage theory If price level is higher than expected, real wages (nominal wages/price level) are falling and real cost is rising, firms have incentive to produce more output If price level is lower than expected, real wages are rising and real cost is falling, firms have incentive to produce less output o Sticky price theory Prices of some goods/services are slow to adjust to changing economic conditions & menu costs (costs to adjusting prices) Inflation can cause higher output (real GDP) in short run o Misperceptions theory Changes in overall price level can temporarily mislead suppliers Aggregate Supply – Long Run & Short Run Adjustment Increase in AD (increase in Investment) o Prices rise, real wages fall & output expands; some businesses mistake a general increase in prices for a relative increase and expand output o Then, firms & workers raise their expectations about the price level (adjust to price level being higher than they expected), shifs SRAS to lef restoring LR equilibrium
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Decrease in AD (decrease in Investment) o SRAS curve shifs to the right with goods/services sold for lower prices until we return to full employment (firms/workers adjust to price level being lower than they expected, costs will fall and cause SRAS shif right) o Then, workers become willing to accept lower wages and firms expect lower prices for their output Determinates of National Output & Inflation Long run – quantity theory of money & production function (real side of economy drives the long term boat) Quantity Theory of Money – M x V = P x Y o Reformulation of QTM %∆M + %∆V = %∆P + %∆Y … assume %∆V = 0 then… %∆P = %∆M - %∆Y o In the long run, inflation is caused by excess growth in a nation’s money supply relative to GDP growth So, if the rate of growth in the money supply = rate of growth in economy (real GDP) there would be no inflation Production Function: Y = f(Labor, Natural Resources, Technology, Physical Capital, Human Capital, Entrepreneurial Ability, Institutions) What determines labor productivity? Adam Smith – labor productivity o Driven by specialization o Division of labor is limited by the extent of the market o Wealth is determined by – labor productivity and productive labor/unproductive labor o A country’s wealth is determined by its ability to produce (and thus to consume) Smithian Growth o
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