Hello pasof,
I have referenced some pictures in this answer. They can be viewed
at: http://www.geocities.com/econ_graphs/index.html
The answer is just about exactly 900 words. If you have any
questions, please let me know. You may also find some of the
following links useful:
Relationship between output, employment and prices:
http://www.digitaleconomist.com/as_4020.html
Tutor2u learning pages on economics:
http://www.tutor2u.net/revision_notes_economics.asp
There is an excellent review of the interaction of LRAS, SRAS,
inflation, and recession here:
http://www.ukpoliticsbrief.co.uk/ASADNU1.pdf
Finally there is another excellent (and lengthy) review of the whole
concept here that I would recommend you take a look at:
http://www.cobeco.net/tagbeyeg/lectures/eco201/Ch06.PDF
Search strategy for these links: "aggregate supply" employment,
"aggregate demand" "aggregate supply" employment, LRAS SRAS employment
I hope this answer proves to be what you need. Let me know if you
need any additions.
--- answer follows ---
The macro economy is based on the notions of aggregate supply (AS) and
aggregate demand (AD). Macroeconomic equilibrium is reached when AS =
AD. Assuming equilibrium is maintained, changes in AS lead to changes
in AD, and vice versa.
Aggregate demand is the total demand for goods and services produced
in the economy over time. The equation is given as Y = C + I + G + (X
– M) where:
Y is national output
C is consumer demand
I is investment spending by companies
G is government spending
X is exports of goods and services
M is imports of goods and services.
A change in any one of these factors leads to a change in national
output Y.
Aggregate demand normally rises as the price level falls. Lower price
levels increase national output because: the real value of money
balances increases, which increases the purchasing power of consumers;
nominal interest rates tend to fall with the price level, increasing
consumer demand and planned investment; exports rise as the price
level falls relative to other countries.
If Investment (I) increases in the economy, this increases national
output (Y) according to the equation Y = C + I + G + (X – M) as long
as all other variables remain constant. This is expressed by an
outward shift of the AD curve. The price level will be affected by
this curve, at least in the short run, by the interaction of the
aggregate demand curve and the short run aggregate supply curve.
Figure 1 shows this relationship.
The short run aggregate supply curve (SRAS) shows the relationship
between the price level and the real GDP that businesses are willing
to sell at that level.
In the short run aggregate supply is assumed to be variable, since
producers respond to changes in the price level, so the SRAS curve has
a positive slope. A shift in AD due to an increase in investment
causes the intersection of AD and SRAS to move from point E1 to E2,
with a rise in output from Y1 to Y2 and a rise in the price level from
P1 to P2 as seen in Figure 1.
In the long run, aggregate supply is assumed to be independent of
prices, meaning it is determined by factors other than demand and
prices. LRAS is a measure of the total productive potential of an
economy, as determined by the productive resources which are available
to meet demand and by the productivity of factor inputs (i.e. land,
labour, and capital). In the short run producers respond to higher
demand by using more inputs in the production process and by
increasing the utilization of their existing inputs. But in the long
run, aggregate supply is modified by changes in productivity and by
changes in the available factor inputs (i.e. number of firms, size of
capital stock, size of active labour force). Since the LRAS does not
respond to the price level, unlike SRAS, it is drawn as a vertical
line. As productivity and efficiency improve the LRAS curve shifts
out. This shift is similar to an outward shift in the production
possibility frontier. Figure 2 shows a shift in LRAS and AD curves
with the price level remaining constant.
In the short run, a rise in AD causes the price level to rise,
assuming an upward sloping SRAS curve (Fig 1). If the nominal wage is
fixed a rise in prices causes the real wage to fall, making labour
less expensive and allowing firms to hire more labour to meet the
increased demand. But over time workers will renegotiate their
contracts and real wages will rise again, causing labour demand to
fall. As price levels rise inflation will temper demand and AD and AS
will equalize once again.
In this case there has been an increase in the level of investment in
the economy. Firms invest in new capital, and an increase in capital
stock will increase the demand for labour. The relationship between
labour, capital, and output can be described by the equation Y =
f(L,K) where:
Y is output
L is quantity and quality of labour inputs
K is capital
With the price level fixed, the labour rate can be graphed against
output (Figure 3). A rise in the amount of labour from L1 to L2
increases potential output from Y1 to Y2 (intersections a and b),
which is a shift along the potential output curve. A rise in the
amount of capital raises the potential output curve from Y = f(L, K)
to Y = f(L, K') (intersection c). At the same labour rate L1 the
economy now increases to potential output level Y3 from Y2. The effect
this has on LRAS is seen in Figure 4. At a constant price level with
rising potential output, LRAS shifts from intersection a to b to c,
LRAS1, LRAS2, LRAS3.
In summary then, an increase in investment causes an outward shift in
aggregate demand which causes a rise in the price level through the
intersection of AD and the SRAS curve. In the long run firms will
invest in more capital, which increases the demand for labour.
Employment rises, output increases with the outward shift in LRAS, and
the price level remains constant.
--- end answer ---
I hope this has proved useful to you. Please let me know if you need
clarification on any of this or if you have trouble accessing or
understanding the graphs.
Hibiscus |
