Question

Why do changes in the price level increase short run economic output? Why do changes in the price level decrease short run economic output? Why don’t changes in the price level have long run impacts on economic growth.

Answer 1

In shortrun input prices are fixed. Most of the labour contracts and resource contracts are delegated for a period of at least on year. During this period the wage rate and resource prices remain constant. Thus an increase in price level gives more profit to the firms. Thus aggregate supply increase in shortrun when price increase.

During shortrun the wages and resource prices are fixed as per the earlier contracts. Thus a fall in price cause loss to the firms since the resource prices do not fall in accordance with the fall in price. Thus in shortrun when the price falls the aggregate supply decrease.

In longrun wages and prices are flexible. An increase in price level correspondingly increases the resource prices. Thus an increase in price level does not give any benefit to the manufacturing units. On the other a fall in price is accompanied by a fall in input prices. Thus aggregate supply does not decrease with fall in price. In other words the actual inflation will be fully adjusted with the inflation expectation in longrun. Thus the changes in price level will not have any impact of economic output in longrun.