The mainstream view of macroeconomic instability emphasizes...

The mainstream view of macroeconomic instability emphasizes sticky prices. To answer the following questions, modify the aggregate supply curve in the extended AD-AS model introduced in Chapter $35 .$ First, imagine that both input and output prices are fixed. What does the aggregate supply curve look like? If AD decreases in this situation, what will happen to equilibrium output and the price level? Next, imagine that input prices are fixed, but output prices are flexible. What does the aggregate supply curve look like? In this case, if AD decreases, what will happen to equilibrium output and the price level? Finally, if both input and output prices are fully flexible, what does the aggregate supply curve look like? In this case, if AD decreases, what will happen to equilibrium output and the price level? (Hint: If you are having trouble drawing these three aggregate supply curves, review the immediate-short-run aggregate supply curve and the short-run aggregate supply curve introduced in Chapter 29 as well as the long-run aggregate supply curve introduced in Chapter $35 .$ )

Key Concepts

Sticky Prices

Sticky prices refer to the phenomenon whereby prices—both of final goods and inputs—do not adjust immediately to changes in economic conditions. This concept is vital in macroeconomics because it explains why, in the short run, output and employment may deviate from their natural levels even when there is a change in aggregate demand. The notion of sticky prices is used to justify the short-run nonneutrality of money and the potential for recessionary gaps.

Price Flexibility

Price flexibility describes the situation where prices adjust rapidly in response to changes in supply or demand. When both input and output prices are flexible, the economy quickly reaches its full employment or natural level of output, and any changes in aggregate demand primarily affect the price level rather than output. This concept is central to understanding the long-run aggregate supply curve, which is vertical.

Aggregate Supply (AS) Curve

The aggregate supply curve represents the relationship between the total quantity of goods and services that producers are willing to supply and the overall price level in the economy. Its shape varies depending on the time frame and the degree of price flexibility: it can be horizontal when both input and output prices are fixed (immediate short-run), upward sloping when there is partial price flexibility (short-run with fixed input prices but flexible output prices), or vertical when prices are fully flexible (long-run).

Short-run vs Long-run Equilibrium

Short-run equilibrium occurs when the economy may operate away from its natural rate of output due to sticky or inflexible prices, leading to an upward sloping aggregate supply curve where shifts in aggregate demand affect both output and prices. In contrast, long-run equilibrium is characterized by full price flexibility where the economy’s output is determined by factors such as technology, labor, and capital, and the aggregate supply curve is vertical. In this scenario, changes in aggregate demand only influence the price level, not the output level.

Aggregate Demand (AD) - Aggregate Supply (AS) Model

The AD-AS model is an essential framework in macroeconomics used to analyze the interplay between total demand and total supply in an economy. It helps explain how changes in factors like fiscal policy, monetary policy, or external shocks impact output and the price level. By considering different assumptions about price flexibility, the model is used to distinguish between immediate, short-run, and long-run responses of the economy to various economic disturbances.

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