Short Run
• Refers to a period where at least one input is fixed, typically capital (e.g., factory size, machinery).
• Firms can only adjust variable factors such as labor or raw materials.
• Output can increase, but only within the limits of fixed resources.
• Example: A restaurant can hire more staff to meet weekend rush but cannot instantly expand the
kitchen.
• Firms face diminishing marginal returns as more variable inputs are added to fixed ones.
• Costs like rent, equipment, and salaries of permanent staff remain fixed, affecting pricing and profit
decisions.
Long Run
• Refers to a time period where all factors of production are variable.
• Firms can adjust their scale—buy more machinery, build new factories, or adopt new technology.
• Allows for entry and exit of firms in the market.
• Example: A company can open a new factory in another city if demand keeps rising.
• Firms aim for productive efficiency, minimizing costs by choosing the best input combinations.
• Important for understanding long-run growth, industry expansion, and economies of scale.
Classical Dichotomy
• A principle in classical economics that separates real and nominal variables.
• Real variables: Output, employment, real wages, real GDP (adjusted for inflation).
• Nominal variables: Money supply, price level, nominal wages (not adjusted for inflation).
• The idea: Changes in nominal variables do not affect real variables in the long run.
• This separation simplifies macroeconomic models, especially in the long run.
• Example: Increasing the money supply will affect prices, but not real output or employment.
Monetary Neutrality
• A concept that supports the classical dichotomy.
• States that changes in the money supply affect only nominal variables in the long run.
• Real economic factors (like GDP, employment) remain unchanged by monetary expansion or
contraction over time.
• Example: If the central bank doubles the money supply, prices may eventually double, but real
output and employment stay the same.
• Holds only in the long run; in the short run, due to sticky prices and wages, money can have real
effects.
Why the Short-Run Aggregate Supply (SRAS) Curve is Horizontal
The horizontal shape of the SRAS curve (especially in Keynesian models) reflects the idea that:
• In the short run, prices are sticky (i.e., do not adjust quickly).
• Firms can increase output without raising prices because they have idle resources like unemployed
labor or underused machinery.
So, at a fixed price level, firms are willing to supply more goods as demand increases. That’s why the
SRAS curve is flat (horizontal) at low levels of output.
Sticky Price Concept :Sticky prices refer to the idea that prices of goods and wages do not
change quickly in response to changes in demand or supply. This stickiness can be due to:
• Long-term contracts (e.g., fixed wages)
• Menu costs (costs of changing prices)
• Firms’ fear of losing customers
• Slow information adjustments
How Sticky Prices Connect to SRAS
• Because prices and wages are sticky in the short run, firms cannot immediately raise prices when
demand increases.
• Instead, they increase production and hire more workers to meet higher demand.
• This explains why output can change in the short run without a change in the price level, keeping
the SRAS curve horizontal or upward-sloping (depending on the model).
So, sticky prices are the core reason for the non-vertical (or horizontal) nature of the SRAS curve
Why the Long-Run Aggregate Supply (LRAS) Curve is Vertical
In the long run:
• Prices and wages are fully flexible.
• The economy is at its full employment level of output (also called potential GDP).
• Changes in aggregate demand do not affect output, only the price level.
Thus, the LRAS curve is vertical because:
• Output is determined only by real factors like technology, capital, labor, and natural resources—not
by the price level.
• The economy self-corrects over time as wages and prices adjust.
• SRAS is horizontal because of sticky prices.
• Sticky prices prevent immediate price changes, so output adjusts instead.
• LRAS is vertical because, in the long run, prices adjust, and output stays fixed at potential GDP.