Question

In: Economics

Let's say a country's long-run equilibrium price level has increased quite dramatically. However, the position of...

Let's say a country's long-run equilibrium price level has increased quite dramatically. However, the position of its aggregate demand curve has not changed. Assuming the LAS Curve remains stationary, what has happened? What specific factors might have accounted for this event? Please explain using concepts we have learned about in the AS/AD Model.

Solutions

Expert Solution

A comparative study between the short run and longrun supply curves shows that the shortrun supply curve is elastic to some extent of price increase while longrun supply curve is inelastic to the price changes. The shortrun supply curve is upward sloping showing that output changes with increase in price. Whereas the longrun supply curve is a vertical curve showing that it is price inelastic. The shortrun supply function can be expressed as Y=Y*+α(P- P e). Y is the total production in the economy, Y* is the natural level of production (fullemployment), P is the price level and Pe is the expected price level. The longrun supply function can be expressed as Y=Y*. Y is the production of the economy and Y* is the natural level of production.

In shortrun the wage is sticky and the increase in price level gives undue advantage to the producers. Since they are operating below the full capacity they can increase output and earn more profit. Thus increase in price level is followed by an increase in supply in shortrun.

But in longrun since the economy is operating at natural level of employment, the output cannot increase even if price increase. Therefore the aggregate supply is price inelastic. The level of output in longrun is determined by the amount of factors and level of technology. The production in the economy in longrun increase with the availability of more factors or with an improvement in technology.   The output may decrease with fall in the availability of factors. But here we assume that the LRAS is stationary.

The price level may increase in longrun with the increase in aggregate demand in longrun. Here we also assume that aggregate demand in longrun is constant. Then what cause the price to increase in longrun without a downward shift in LRAS or an upward shift in LRAD.

The price level in longrun may increase without increase in aggregate demand or a decrease in AS. In the absence of changes is AD and AS the only factor which changes the longrun price level is the labour productivity. The fall in labour productivity increase the cost of production of firms. Thus in longrun if the labour productivity falls substantially, the price level increase without any increase in LRAD and decrease in LRAS. Thus the major factor which increases the price level in longrun is the fall in productivity of labour when aggregate supply and aggregate demand remain constant.


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