The distinction between long run & short run phases in an
economy is defined by the behavior of Aggregate Supply (AS). As we
have seen previously, the long run AS doesnt respond to price
changes, however the short run AS is responsive to price &
there is a direct relationship between price & quantity of
goods & services supplied. They move in the same direction.
Hence the short run AS is upward sloping.
Why is AS curve upward sloping:Macroeconomist have formed three
theories to explain why the AS curve is upward sloping in the short
run All these three theories share one common implication; whenever
price deviates from expected level ( the level that the people
expected the general price to be at), quantity supply of output
deviates from its long run natural rate level. Higher than expected
price implies higher than natural rate of output, lower than
expected price implies lower than natural rate of output.
The three theories explaining why AS is upward sloping:The
Sticky Wage Theory: Nominal wage being set based on expected price
level-actual price level may be higher or lower-cost of production
varying accordingly-employment & output varying accordingly in
the short run.The Sticky Price Theory: due to presence of Menu Cost
not all firms change price simultaneously towards the general price
level. Some firms can lag behind & depending on whether the
price level is higher or lower than the long run trend will
accordingly induce more quantity supplied, or less quantity
supplied of goods & services.The Misperception Theory: When
general price level is rising/ falling supplier may be under the
misperception that their relative prices has risen/fallen, they
will then adjust quantity supply of output accordingly. It also
applies in case of nominal wage, when nominal wage is falling
worker might not perceive that the overall price level is also
falling, hence react by increasing/decreasing labor supply.
Summing up the theories: Quantity of Output Supplied: Natural
Rate of Output+ a( Actual Price Level-Expected Price Level)As
mentioned previously, we are seeing a deviation in output from its
long run natural rate, when actual price level is different from
expected level.Its important to note that all the theories present
a temporary scenario, hence the short run, in the long run wages,
prices & misperceptions are all adjusted according to the long
run trend.
Factors that can shift the short run AS curve:All the factors
that can shift the long run AS can also shift the short run AS.
E.g. capital, labor are factors which shifts both the long run
& short run AS. However, in addition to these factors, the
expected price level is the additional factor which can shift the
short run AS. The three theories which tries to explain why the
short run AS is upward sloping, are all based on the expected price
level. So when expectation of people regarding price level changes,
the short run AS shifts.
Taking the case of Sticky Wage Theory again; when expected price
level is high, nominal wage level also tends to be high, cost of
production rise, output level falls & AS curve shifts to the
left & vice versa. During short run the expectations of price
level by people are fixed, in the long run these expectations
adjust & this in turn causes the AS curve to shift & it
shifts towards the long run AS level.
Effects of shift in Aggregate Demand (AD):Output level
falls-Employment level falls-Price level falls- recession &
unemployment happens- due to lower price, expected price level is
low, so short run AS curve shifts up-the economy moves back to its
natural rate of output at a lower price level.
Effects of shift in Aggregate Supply (AS):
Output level falls & price rises-leads to
Stagflation.Stagflation: falling output (recession) & rising
prices ( Inflation)Rising prices leads to rising nominal wage-this
in turn leads to wage-price spiral-however eventually falling
output & lower level of employment leads to lower nominal wage
level-again short run AS curve shifts up to the long run level of
output at a lower price level.The government can push up Aggregate
Demand to counter the effect of falling Aggregate Supply, this will
restore the economy to its natural rate & avoid falling output
& employment, but the price will be at a permanently higher
level.
