No Such Thing as a Free Lunch: Principles of Economics (Part 137)

Economics, politics, and personalities are often inseparable.

Charles Edison

Aggregate Demand, Aggregate Supply, and Inflation

(Part F)

by

Charles Lamson

The Equilibrium Price Level

Figure 9 looks simple, but it is a powerful device for analyzing a number of macroeconomic questions. Consider first what is true at the intersection of the AS and AD curves. Each point on the AD curve corresponds to equilibrium in both the goods market and the money market. Each point on the AS curve represents the price/output responses of all the firms in the economy. This means:

The point at which the AS and AD curves intersect corresponds to equilibrium in the goods and money markets and to a set of price/output decisions on the part of all the firms in the economy.

 We will use this AS/AD framework to analyze the effects of monetary and fiscal policy on the economy and to analyze the causes of inflation. First we need to return to the AS curve and discuss its shape in the long run.

The Long-Run Aggregate Supply Curve

For the AS curve not to be vertical, some costs must lag behind increases in the overall price level. If all prices (both input and output prices) change at the same rate, the level of aggregate output does not change. We have assumed that in the short run at least some cost changes lag behind price level changes, but what happens in the long run?

Many economists believe costs lag behind price level changes in the short run but ultimately move with the overall price level. For example, wage rates tend to move very closely with the price level over time. If the price level increases at a steady rate, inflation may come to be fully anticipated and built into most labor contracts.

If wage rates and other costs fully adjust to changes in prices in the long run, then the long-run AS curve is vertical.

Potential GDP

Recall that even the short-run AS curve becomes vertical at some particular level of output. The vertical portion of the short-run curve exists because there are physical limits to the amount that an economy can produce in any given time period. At the physical limit, all plants are operating around the clock, many workers are on overtime, and there is no cyclical unemployment.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 544-546*

end