February 13, 2008

SRAS Shift Discussion

Posted in Aggregate Supply, Assignments at 3:45 pm by davidprudente

Hey Folks,

I’m glad to see many of you working on your day off. Juan Vega and I exchanged email’s earlier and I thought the discussion might help.

Juan Asks:

“On page 722, Mankiw says that when the AD curve decreases because of a wave of pessimism, the quantity of output and the price level decrease. According to Mankiw, this is a recession because output has fallen and therefore unemployment has risen. I understand this, but then he goes on and says that without intervention by policy-makers the economy will remedy itself when perceptions, wages, and prices change. My question is, how can the SRAS curve shift to the right when the price level is low? Doesn’t a low price level lead to cuts in production due to perceptions, wages, and sticky prices, as explained by Mankiw on page 717?”

My Answer:

Good question. Remember that the short-run fluctuation is a deviation from the natural-rate of output in the long-run. So the natural tendency is to shift towards the long-run aggregate supply over time. For example, let’s say we are currently in a recession and our unemployment rate is 8%. Prices and output would be low in this situation (think about the graph). During a recession, businesses would be trying to lower output and cut costs. One way they do this is by letting their inventories decrease. At the same time, consumers have generally put-off major purchases (cars, houses, other durable goods) because they are concerned about a recession. But after awhile, some major purchases can no longer be put off (if you need a new car for transportation you have to buy one now rather than later). As more and more consumers begin purchasing goods out of necessity, businesses start seeing rising demand for their goods. So businesses start to increase their output. As this occurs, they hire more workers, who inevitably spend their wages. As more and more workers begin being hired and consequently spend their wages, more and more businesses increase output and hire more workers. Soon the unemployment rate begins to decline (gravitating towards the natural rate of output or full employment level). Now we see that our SRAS begins to shift right towards the LRAS.

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1 Comment »

  1. Brian Sobiecki said,

    http://www.engadget.com/2008/02/13/google-releases-new-android-sdk/

    interesting. I wonder what phones are going to be based on the platform and what prices are going to be like


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