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Example 6B: When the economy is in an inflationary gap, the shortage of labor will cause wage<br />

rates to rise. The increase in wage rates will increase the overall costs of production, shifting the<br />

SRAS curve to the left until Natural Real GDP is reached.<br />

Price<br />

Level<br />

Q N<br />

$18500B $19000B<br />

Real GDP<br />

SRAS 2 SRAS1<br />

Notice on the graph in Example 6B above that the adjustment from an inflationary gap to Natural<br />

Real GDP results in an increase in the price level.<br />

Long-Run Aggregate Supply<br />

The concept of aggregate supply was introduced in Chapter 6, where we focused on the shortrun<br />

aggregate supply curve. Now we need to consider the long-run aggregate supply curve.<br />

The short-run aggregate supply curve indicates a direct relationship between the price level and<br />

the quantity supplied of Real GDP. As a result, an increase in aggregate demand will cause an<br />

increase in both the price level and the quantity of Real GDP. A decrease in aggregate demand<br />

will cause a decrease in both the price level and the quantity of Real GDP. These changes are<br />

illustrated on the graph in Example 7 on the next page.<br />

But what does the long-run aggregate supply curve (LRAS) look like? According to classical<br />

theory, the economy is self-regulating. If Real GDP deviates from Natural Real GDP with a<br />

recessionary gap or an inflationary gap, the deviation is only temporary. Since the economy is<br />

self-regulating, Real GDP will always tend to adjust back to Natural Real GDP. Thus, the long-run<br />

aggregate supply curve will be vertical at Natural Real GDP.<br />

If the LRAS curve is vertical at Natural Real GDP, then an increase in AD will have no effect on<br />

total output (Real GDP) in the long run, but will only cause the price level to increase. And a<br />

decrease in AD will have no effect on total output (Real GDP) in the long run, but will only cause<br />

the price level to decrease. These changes are illustrated on the graph in Example 8 on the next<br />

page.<br />

FOR REVIEW ONLY - NOT FOR DISTRIBUTION<br />

AD<br />

7 - 7 Classical Economic Theory

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