Let's turn to the long run aggregate supply curve which is depicted as a vertical line. The LAS represents the level of output that the economy produces when unemployment is at its natural rate. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.

Can you explain three important factors that may cause such a shift in the LAS and how?

 

Let's turn to the long run aggregate supply curve which is depicted as a vertical line. The LAS represents the level of output that the economy produces when unemployment is at its natural rate. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.

Can you explain three important factors that may cause such a shift in the LAS and how?

Step-by-step explanation

The long-term AS curve, ie the natural production volume, only changes due to changes in real or human capital (volume, training), technical progress or changes in natural resources (new development or exhaustion). This exogenous change is not included in the graph. The starting point is always long-term equilibrium.

Model of imperfect information

The basic assumptions of the model are market clearance with flexible prices and wages. The short and long term differ in their different assessments (misjudgments) with regard to the relative prices. Producers know the price development of their goods exactly, but the development of the general price level only imprecisely. When the price level rises, he perceives this primarily on the basis of the price of the goods he has produced and concludes that the relative price of his goods has risen, since he can only estimate the price development of other goods due to a lack of information. The (perceived) increase in the relative price of the goods justifies an expansion of production. Since this applies to all producers, the aggregated supply also reacts positively to price increases.

Model of rigid wages

Fixed or sluggish nominal wages can arise due to collective agreements, social norms, adjustment costs, lags in operational processes, etc. With rigid nominal wages W. leads to an increase in the price level P to falling real wages W. P and, as a result, increasing employment and a higher supply of goods Y S.. In fact, the expected price level usually plays a decisive role in wage negotiations. If the price level is later above the expected level, the real wage is lower than expected and employment is expanded as described above. An (unexpected) increase in the price level leads to a higher output and the supply curve has a positive slope.

Model of the nominal wage illusion

The basic assumption of the model is that employees are not able in the short term to differentiate between nominal and real wages. They are under the illusion that a nominal wage increase is an increase in real wages. Similar to the rigid wage model, an increase in the price level leads to a decrease in the real wage and thus to more employment and a higher aggregate supply. Raising the nominal wage to compensate for inflation is not necessary due to the nominal wage illusion.

This pattern cannot be observed with this sharpness in reality. However, if various effects, such as increasing productivity and inflation, are mixed up, an underestimation can be established in some cases. In Germany, for example, real wages fell by around 3.6 between 2003 and 2009. The problem with the models of wage rigidity and nominal wage illusion is that they predict ant cyclical behavior of real wages and production, but empirically at most a weak procyclical relationship can be proven.

Price rigidity model

This New Keynesian theory of rigid (lazy) prices is based on the assumption that prices are not immediately adjusted to changes in demand. Reasons can be, for example, long-term supply contracts, customer annoyance in the event of frequent price changes, high menu costs (costs of price changes such as printing and sending new catalogs or price lists) or uncertainty about the sustainability of the change in demand. The inertia of prices is represented in the model by the fact that only some of the companies can adjust their prices in each period. If the price level rises, there will be more demand for products from companies that have not yet adjusted their prices, since these are then relatively cheaper. The increased demand then leads to higher production and increases the aggregate supply.