Week 7 Lecture 1 Flashcards
How does a decrease in the price level affect the quantity of goods and services supplied in the short run?
A decrease in the price level reduces the quantity of goods and services supplied in the short run
Draw a diagram to show how a decrease in the price level in the short run affects the quantity of goods and services supplied
See slide 4 in Week 7 Lecture 1
What three theories are used to explain why the AS curve slopes upwards in the short run?
- Sticky-wage theory
- Sticky-price theory
- Misperceptions theory
What are each of the three theories used to explain why the AS curve slopes upwards in the short run based on and what do they focus on?
Each of the three theories are based on some form of market imperfection and they focus on the difference between the expected price level and the actual price level
What is the effect on the natural rate of output when the price level rises above and below the expected price level?
- When the price level rises above the expected price level, output rises above its natural rate
- When the price level falls below the expected price level, output falls below its natural rate
What is Sticky-wage theory?
- Sticky-wage theory occurs when nominal wages are slow to adjust to changing economic conditions
- An example of this is Labour contracts being fixed in the medium term
What are nominal wages based on?
- Nominal wages are based on expected prices
- Wages don’t respond immediately when the actual price level is different from what was expected, they adjust with a lag
What does sticky-wage theory imply about the SRAS curve?
Sticky-wage theory implies an upward sloping SRAS curve because the real wage is the firm’s marginal cost of labour
Use sticky-wage theory to explain what happens to output when the actual price level is less than the expected price level
- Real wages are higher than firms expected
- This means firm’s actual marginal costs are greater than expected and planned for hence firms cut production and hire fewer workers so output falls
Use sticky-wage theory to explain what happens to output when the actual price level is greater than the expected price level
- Real wages (hence costs) are now lower than firms expected
- So firms increase production and output increases
What is sticky-price theory?
- Sticky-price theory refers to a situation where prices of most goods and services are fixed or slow to adjust in the short term
- Eg. Prices are costly to change due to menu costs
What does sticky-price theory imply about the SRAS curve?
Sticky-price theory implies an upward sloping SRAS curve since prices are firm’s marginal revenues
Use sticky-price theory to explain what happens to output when the actual price level is less than the expected price level
If actual prices are lower than expected prices then actual revenue is lower than expected and planned for so some firms are forced to cut production which reduces the aggregate supply of goods and services in the economy
Use sticky-price theory to explain what happens to output when the actual price level is greater than the expected price level
Firms will increase output
What is misperceptions theory?
Misperceptions theory occurs when changes in the overall price level can temporarily mislead suppliers about price changes in relevant relative prices
What does misperceptions theory imply about the SRAS curve?
Misperceptions theory implies an upward sloping SRAS curve
Give an example of misperceptions theory
- Suppose actual overall prices are below the expected price level
- If individual firms interpret the fall in the overall price level as a fall in their prices, they misperceive their marginal revenues and reduce production
- The opposite is true if general price levels are above expectation
State the equation used to summarize all three theories
Ysupply = Ynatural + a(Pactual - Pexpected)
- Ysupply is the quantity of output supplied
- Ynatural is the natural rate of output (=LRAS)
- a determines how much output responds to unexpected changes in the price level
When does the natural rate of output occur?
When the actual price level is equal to the expected price level
Draw a diagram indicating where long run equilibrium occurs
See slide 12 of Week 7 Lecture 1
When does the SRAS curve shift?
- The SRAS curve shifts with any changes in factors that shift the LRAS curve
- The SRAS curve also shifts with expectations such as expected price levels
- For example higher expected price levels will cause SRAS to shift left as higher prices mean that higher nominal wages will be negotiated which implies increasing production costs and reducing output
