Describe the characteristics of the long-run aggregate supply curve. Explain how changes in the price level affect the short-run aggregate supply curve and the long-run aggregate supply curve.
What will be an ideal response?
The long-run aggregate supply curve will be vertical at the full-employment level of output. Changes in the price level will not affect the full-employment level of output in the long run. Changes in the short-run aggregate supply curve will define the long-run aggregate supply curve at the full-employment level of output.
With the short-run aggregate supply curve, as the price level increases from the full-employment level of output along the curve, revenues to the firm increase because nominal wages are fixed, and the profits for firms will rise. Firms will have an incentive to increase output and employment (hiring temporary or part-time workers or paying for overtime), so real GDP will increase and unemployment will fall below its natural rate. This situation is a short-run one because nominal wages (and other input prices) will eventually increase and shift the short-run aggregate supply curve to the left. The new equilibrium will return to the full-employment level of output, but at a higher price level.
Conversely, as the price level decreases from the full-employment level of output, revenues to the firm decrease and because nominal wages are fixed, the profits for firms will decrease. Firms will have an incentive to decrease output and employment, so real GDP will decrease and employment will fall below its natural rate. This situation is a short-run one because nominal wages (and other input prices) will eventually decrease and shift the short-run aggregate supply curve to the right. The new equilibrium will return to the full-employment level of output, but at a lower price level.
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