Question

1. Explain why the long-run aggregate supply (LRAS) curve is vertical while the short-run aggregate supply (SRAS) curve slope upwards. List and discuss briefly the variables that could cause the LRAS and the SRAS curves to shift. For each variable, identify whether an increase in that variable will cause the curves (LRAS and SRAS curves) to shift to the right or to the left.

2. What are the main roles of the Reserve Bank of Australia (RBA)? How does the RBA control liquidity in the overnight money market? Explain briefly why an open market purchase of government securities by the RBA increase bank reserves while an open market sale of government securities by the RBA decrease bank reserves.

3. What is inflation targeting? How does inflation targeting help to achieve the main goals of monetary policy?

Answer 1

Ans 1 - The long-run aggregate supply curve is vertical which reflects economists’ beliefs that changes in the aggregate demand only temporarily change the economy’s total output. In the long-run, only capital, labor, and technology affect aggregate supply because everything in the economy is assumed to be used optimally. The long-run aggregate supply curve is static because it is the slowest aggregate supply curve.

The Slope of the Short-Run Aggregate Supply Curve

In the short-run, the aggregate supply curve is upward sloping. There are two main reasons why the quantity supplied increases as the price rises:

1. The AS curve is drawn using a nominal variable, such as the nominal wage rate. In the short-run, the nominal wage rate is fixed. As a result, an increasing price indicates higher profits that justify the expansion of output.
2. An alternate model explains that the AS curve increases because some nominal input prices are fixed in the short-run and as output rises, more production processes encounter bottlenecks. At low levels of demand, large numbers of production processes do not make full use of their fixed capital equipment. As a result, production can be increased without many diminishing returns. The average price level does not have to rise much in order to justify increased production. In this case, the AS curve is flat. Likewise, when demand is high, there are few production processes that have unemployed fixed outputs. Any increase in demand production causes the prices to increase which results in a steep or vertical AS curve.

In the short-run, firms possess fixed factors of production, including prices, wages, and capital. It is possible for the short-run supply curve to shift outward as a result of an increase in output and real GDP at a given price. As a result, the short-run aggregate supply curve shows the correlation between the price level and output.

The Slope of the Long-Run Aggregate Supply Curve

The long-run aggregate supply curve is perfectly vertical; changes in aggregate demand only cause a temporary change in total output.

Long-run Aggregate Supply Curve

In the long-run, only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long-run aggregate supply curve is static because it shifts the slowest of the three ranges of the aggregate supply curve. The long-run aggregate supply curve is perfectly vertical, which reflects economists’ belief that the changes in aggregate demand only cause a temporary change in an economy’s total output. In the long-run, there is exactly one quantity that will be supplied.

The long-run aggregate supply curve can be shifted, when the factors of production change in quantity. For example, if there is an increase in the number of available workers or labor hours in the long run, the aggregate supply curve will shift outward (it is assumed the labor market is always in equilibrium and everyone in the workforce is employed). Similarly, changes in technology can shift the curve by changing the potential output from the same amount of inputs in the long-term.

For the short-run aggregate supply, the quantity supplied increases as the price rises. The AS curve is drawn given some nominal variables, such as the nominal wage rate. In the short run, the nominal wage rate is taken as fixed. Therefore, rising P implies higher profits that justify the expansion of output. However, in the long run, the nominal wage rate varies with economic conditions (high unemployment leads to falling nominal wages — and vice-versa).

Short-run Aggregate Supply

During the short-run, firms possess one fixed factor of production (usually capital). It is possible for the curve to shift outward in the short-run, which results in increased output and real GDP at a given price. In the short-run, there is a positive relationship between the price level and the output. The short-run aggregate supply curve is an upward slope. The short-run is when all production occurs in real-time.

Long-run Aggregate Supply

In the long-run only capital, labor, and technology impact the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long-run supply curve is static and shifts the slowest of all three ranges of the supply curve. The long-run curve is perfectly vertical, which reflects economists’ belief that changes in aggregate demand only temporarily change an economy’s total output. The long-run is a planning and implementation stage.

Moving from Short-run to Long-run

In the short-run, the price level of the economy is sticky or fixed depending on changes in aggregate supply. Also, capital is not fully mobile between sectors.

In the long-run, the price level for the economy is completely flexible in regards to shifts in aggregate supply. There is also full mobility of labor and capital between sectors of the economy.

The aggregate supply moves from short-run to long-run when enough time passes such that no factors are fixed. That state of equilibrium is then compared to the new short-run and long-run equilibrium state if there is a change that disturbs equilibrium.

Reasons for and Consequences of Shifts in the Short-Run Aggregate Supply Curve

The short-run aggregate supply shifts in relation to changes in price level and production.