Mr. Maurer
AP Economics (Macro)
Name: __________________________
Long-Run Aggregate Supply – Problem Set #1
In this activity we move from the short run to the long run. In the short run, the cost of at least one
factor of production is fixed. In the long run, the costs of all factors of production are variable. The
short-run aggregate supply curve (SRAS) is upward sloping because of slow wage and price
adjustments in the economy. But in the long run, wages and prices have time to adjust. That is, wages
and prices are fully flexible. This means that any time the price level changes (i.e. there is inflation or
deflation), wages and other input costs fully adjust so there is no overall effect to output or real wages.
For example, if prices doubled and wages and other factor costs also doubled, there would be no
overall effect. In the long run, wages and other input costs do adjust, so the economy always returns to
the full-employment level of output (remember that “full employment” means the employment of both
labor and other resources at that point where there is neither upward nor downward pressure on wages
and input prices). This means that the long-run aggregate supply curve (LRAS) is vertical at the fullemployment level of output (which is also called potential output and corresponds to the natural rate of
unemployment).
1. Assume that, with the economy already at full
employment, aggregate demand increases, as pictured in the
graph at left. What will be the short-run effect on the
following:
a. output
b. unemployment
c. price level
d. nominal wages
e. real wages.
Indicate the new output level and price level on the graph and
label them Y2 and PL2
2. What will happen to output and price level in the long run? Demonstrate this on the graph, indicating
the long-run price level after the return to long-run equilibrium. Explain how this return to long-run
equilibrium will occur.
3. If the government wanted to prevent the increase in price level that would occur as the economy
returned to long-run equilibrium in the scenario above, what fiscal or monetary policy could it initiate in
order to try to achieve a more favorable outcome? Explain.
4. Assume now that there has been a decrease in
aggregated demand as shown in the graph at left. What
will be the short-run effect on the following:
a. output
b. unemployment
c. price level
d. nominal wages
e. real wages.
Indicate the new output level and price level on the
graph and label them Y2 and PL2
5. What will happen to output and price level in the
long run? Demonstrate this on the graph, indicating
the long-run price level after the return to long-run equilibrium. Explain how this return to long-run
equilibrium will occur.
6. If the government wanted to reduce the short-run unemployment that would occur as the economy
returned to long-run equilibrium in the scenario above, what fiscal or monetary policy could it initiate in
order to try to achieve a more favorable short-run outcome? Explain.
7. Assume now that short-run aggregate supply shifts as
indicated in the diagram at left. What do economists call this
type of left-ward shift in SRAS? Give a historical example of
such a shift.
8. What unique effect will this situation have on both
unemployment and price level.
9. What will happen to real wages in the short-run? Explain.
9. As you did before, indicate on the graph and explain how the economy will return to long-run
equilibrium in the absence of government intervention.
10. Referring back to the previous graph, what options does the government have to reduce
unemployment? What is the downside of fiscal or monetary policy to increase demand in the situation?
11. On the other hand, if the government does nothing, what is the downside to allowing the economy to
return to long-run equilibrium on its own?
For the following problems, read the description for each change in AD or SRAS. Draw a graph
showing the starting point as long-run equilibrium. Draw a new AD or SRAS curve that represents the
change caused by the event described. Explain the change for the short-run change in the graph, then
explain how the economy would return to long-run equilibrium in the absence of government
intervention. Label the final AD curve ADf and the final SRAS curve SRASf.
12. OPEC (The Organization of Petroleum Exporting Countries) cuts oil production by 30%, driving oil
prices up.
13.The government increases spending on education, health care, housing, and basic services for lowincome people.
14. The development of a new microprocessor increases computer speeds and improves workplace
productivity by 25%.
15. A crisis in the financial markets causes banks to be hesitant to loan out their excess reserves (meaning
they keep a larger percentage of their reserves in cash or in securities, rather than creating new loans.)
16. Due to a drop in the stock market, consumers feel less wealthy than they did last year.