The Extended Ad As Model And The Phillip's Curve.

1330 words - 5 pages

THE EXTENDED AS-AD MODELIn order to understand the effects of inflation in the long run, lets first analyze the long run aggregate demand (AD) and aggregate supply (AS) curves in the long run through the extended AS-AD model.SHORT-RUN AND LONG-RUN AGGREGATE SUPPLYShort RunIt is the period in which nominal wages (and other input prices) remain fixed as the price level increases or decreases.Causes of fixed nominal wages:* Workers may not immediatel y be aware of the extent that inflation or deflation has changed their real wages, and thus they may not adjust their labor supply decisions and wage demands accordingly.* Many employees are hired under fixed-wage contracts. For unionized employees their prospective wages are set for 2 years. Other professionals too have annual contracts.For the reasons mentioned above, price- level changes don't immediately give rise to changes in nominal wages in the short run.The short period can also be explained with the help of a graph. In this graph, only the intermediate range of the AS curve has been considered. In the short run, nominal wages a re fixed and based on price level P1 and the expectation that it will continue. An increase in the price level from P1 to P2 increases profits and output moving the economy from a1 to a2; a decrease in the price level from P1 to P3 reduces profits and real output, moving the economy from a1 to a3. The short run aggregate supply curve therefore slopes upward.Long RunIt is the period in which nominal wages are fully responsive to previous changes in the price level. Let us illustrate this by a graph. Suppose that the economy is initially at point a1 (P1 and QF). When the price level will increase from P1 to P2, the labor will press for higher nominal wages. The prices of the inputs will also increase which will lead to a rise in cost of production. In the long run the workers will realize that their real wages have declined because of this increase in the price level. They restore their previous level of real wages by gaining nominal wage increases. This will shift the supply curve leftward to AS2 which now reflects the higher price level P2. The leftward shift in the short urn aggregate supply curve to AS2 moves the economy from a2 to b1. Real output falls back to its full employment level Qf and the unemployment rate rises tot its natural rate. Conversely, a decrease in the price level reduces nominal wages and shifts the short urn aggregate supply curve to the right. After such adjustments, the economy obtains equilibrium at points such as b1 and c1. Tracing a line between these points will give us the vertical longer un supply curve. After long run adjustments in nominal wages, real output is Qf regardless of the specific price level.Long run equilibrium:In the long run equilibrium, the aggregate demand will be qual to the short run supply as well as the long run supply curve.With this detailed discussion of the AS-AD model let us now move to our main topic i.e....

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