Notes on Long Run Aggregate Supply and Real GDP

In the long run, the relationship between price levels and real GDP is distinct from the short run.
In the short run:
- The aggregate supply curve is upward sloping due to sticky input prices.
- An increase in price level (e.g., from 100 to 110):
- Results in a higher quantity of real GDP (increase from $y1$ to $y2$).
- A decrease in price level leads to a lower quantity of real GDP.

As we transition to the long run, input prices become flexible, altering the dynamics:
- Example scenario:
- Price level increases from 100 to 110.
- Firms respond by hiring more workers to increase production.
- However, this leads to rising labor demand, increasing wages once contracts expire.
- Victor's case illustrates this phenomenon:
  - Initial labor cost: $3,000;
  - After wage increases: labor cost rises to $3,300, reducing profits to $0.
Resulting actions by Victor:
- Unable to sustain increased production due to heightened labor costs.
- Must reduce output to levels consistent when the price level was 100.
Long-run outcome:
- Economy adjusts: output falls back to full employment level of real GDP, $y_1$, even at the elevated price level of 110.

When the price level decreases:
- Price falls from 100 to 90 results in reduced hiring by firms, leading to increased unemployment in the short run.
- Over time:
- Workers compete for jobs, leading to a decrease in labor costs.
- Victor’s labor costs decrease from $3,000 to $2,700, mitigating his financial losses.
- Resulting actions by Victor:
- This cost reduction enables Victor to hire more labor and increase production again.
Long-run result:
- As input prices readjust:
- Economy experiences a rise in output returning to full employment level of real GDP, $y_1$, but now at a price level of 90.