Defining sras and lras
In the Clear It Up feature titled “Why does AS cross potential GDP?” we differentiated between short run changes in aggregate supply which are shown by the AS curve and long run changes in aggregate supply which are defined by the vertical line at potential GDP. In the short run, if demand is too low (or too high), it is possible for producers to supply less GDP (or more GDP) than potential. In the long run, however, producers are limited to producing at potential GDP. For this reason, what we have been calling the AS curve, will from this point on may also be referred to as the short run aggregate supply (SRAS) curve . The vertical line at potential GDP may also be referred to as the long run aggregate supply (LRAS) curve .
Key concepts and summary
The upward-sloping short run aggregate supply (SRAS) curve shows the positive relationship between the price level and the level of real GDP in the short run. Aggregate supply slopes up because when the price level for outputs increases, while the price level of inputs remains fixed, the opportunity for additional profits encourages more production. The aggregate supply curve is near-horizontal on the left and near-vertical on the right. In the long run, aggregate supply is shown by a vertical line at the level of potential output, which is the maximum level of output the economy can produce with its existing levels of workers, physical capital, technology, and economic institutions.
The downward-sloping aggregate demand (AD) curve shows the relationship between the price level for outputs and the quantity of total spending in the economy. It slopes down because of: (a) the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption; (b) the interest rate effect, which holds that a higher price level will mean a greater demand for money, which will tend to drive up interest rates and reduce investment spending; and (c) the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.
Problems
Review the problem shown in the Work It Out titled "Interpreting the AD/AS Model." Like the information provided in that feature, [link] shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.
Price Level | AD | AS |
---|---|---|
110 | 700 | 600 |
120 | 690 | 640 |
130 | 680 | 680 |
140 | 670 | 720 |
150 | 660 | 740 |
160 | 650 | 760 |
170 | 640 | 770 |
- Plot the AD/AS diagram from the data shown. Identify the equilibrium.
- Imagine that, as a result of a government tax cut, aggregate demand becomes higher by 50 at every price level. Identify the new equilibrium.
- How will the new equilibrium alter output? How will it alter the price level? What do you think will happen to employment?
The imaginary country of Harris Island has the aggregate supply and aggregate demand curves as shown in [link] .
Price Level | AD | AS |
---|---|---|
100 | 700 | 200 |
120 | 600 | 325 |
140 | 500 | 500 |
160 | 400 | 570 |
180 | 300 | 620 |
- Plot the AD/AS diagram. Identify the equilibrium.
- Would you expect unemployment in this economy to be relatively high or low?
- Would you expect concern about inflation in this economy to be relatively high or low?
- Imagine that consumers begin to lose confidence about the state of the economy, and so AD becomes lower by 275 at every price level. Identify the new aggregate equilibrium.
- How will the shift in AD affect the original output, price level, and employment?
Santher is an economy described by [link] .
Price Level | AD | AS |
---|---|---|
50 | 1,000 | 250 |
60 | 950 | 580 |
70 | 900 | 750 |
80 | 850 | 850 |
90 | 800 | 900 |
- Plot the AD/AS curves and identify the equilibrium.
- Would you expect unemployment in this economy to be relatively high or low?
- Would you expect prices to be a relatively large or small concern for this economy?
- Imagine that input prices fall and so AS shifts to the right by 150 units. Identify the new equilibrium.
- How will the shift in AS affect the original output, price level, and employment?