Question

a. What assumptions are made to justify the shape of the short-run aggregate supply curve; i.e., that it is horizontal at a given price level?

b. What assumptions are made to justify the shape of the long-run aggregate supply curve; i.e., that it is vertical at a full-employment level of output?

c. Recently, oil prices have been declining in the U.S. Oil prices hovered around $100 per barrel during much of 2013 and 2014. During 2015 until the present day, oil prices have hovered closer to $50 per barrel. All else equal (ignoring many other changes in the U.S. economy), how should the lower oil prices, around $50 per barrel compared with around $100 per barrel, affect the price level, unemployment, and real income in the United States? Explain using a diagram, and consider only short-run aggregate supply, and not the long-run aggregate supply.

Answer 1

a) The short run aggregate supply curve is nearly perfectly horizontal . Even if ouput increases in the economy price does not change much . The assumptions underlying are that in the short run one of the factors of production /9 specially capital ) is fixed . Only labor can be changed to change production levels . Thus most of the resources are under used during short run . Wages or the price of labor do not change over the short run , so price is almost unaffected . But the quantity of aggregate output produced becomes highly sensitive to the price level , since price level is the only output determining factor is short run . So it is horizontal in nature . A small change in price brings infinitesinal change in quantity supplied .

b) Over the long run we expect that every resource ( land , labor , capital , technology ) in the economy is used optimally . In most situations, the LRAS is viewed as static because it has already reached full employment potential . Hence it is vertical or highly inelastic . Changes in price cannot affect output as the economy is already at full potential .

c) The fall in oil prices has significant impact on the economy since it reduces transport costs and costs of inputs where oil is used as an input . It reduces inflation and raises standard of living . Lower oil prices can boost production and lead to higher real income . Nominal wages remaining constant , it leads to rise of purchasing power . Output rises in the economy , infaltion or price level falls . Employment rises in the economy . So the SRAS will shift rightward because at lower oil price firms can produce more .