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THE EXTENDED AS-AD MODEL In order to understand the effects of inflation in the long run lets first analyze the long run aggregate demand AD and aggregate supply AS curves in the long run through the extended AS-AD model SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY Short Run It is the period in which nominal wages and other input prices remain fixed as the price level increases or decreases Causes of fixed nominal wages Workers may not immediatel y be aware of the extent that inflation or deflation has changed their real wages and thus they may not adjust their labor supply decisions and wage demands accordingly Many employees are hired under fixed-wage contracts For unionized employees their prospective wages are set for 2 years Other professionals too have annual contracts For the reasons mentioned above price- level changes dont immediately give rise to changes in nominal wages in the short run The short period can also be explained with the help of a graph In this graph only the intermediate range of the AS curve has been considered In the short run nominal wages a re fixed and based on price level P1 and the expectation that it will continue An increase in the price level from P1 to P2 increases profits and output moving the economy from a1 to a2 a decrease in the price level from P1 to P3 reduces profits and real output moving the economy from a1 to a3 The short run aggregate supply curve therefore slopes upward Long Run It is the period in which nominal wages are fully responsive to previous changes in the price level Let us illustrate this by a graph Suppose that the economy is initially at point a1 P1 and QF When the price level will increase from P1 to P2 the labor will press for higher nominal wages The prices of the inputs will also increase which will lead to
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