Lecture 15 - Labor Market Equilibrium and Long Run Aggregate Supply

Labor Demand and Supply Curves: Inclusion of labor supply, usually upward sloping, to intersect with labor demand, determining equilibrium.
Equilibrium Real Wage and Employment: The point where labor supply and demand intersect; equilibrium real wage will adjust in the long run.

Short-Run Assumptions: Nominal wages are considered fixed in the short run.
Long-Run Adjustments: Nominal wages are flexible; they will adjust to ensure labor market equilibrium if there are any imbalances due to unchanged nominal wages in the short run.

Full Employment Level of Output: LRAS denotes the economy's capacity output at full employment.
- Example: If equilibrium real wage is 10 and price level is 3, nominal wage adjusts to 30 ($W = 30$; $W/P = 10$).
- Output level remains at $Y_f$ irrespective of the price level, assuming labor market equilibrium.
Shifting the LRAS Curve: Changes in productivity or other factors affect full employment output, shifting the LRAS curve.

Price Increase: If price level increases (say $P = 5$), nominal wage adjusts to 50 ($W = 50$; $W/P = 10$); output remains at $Y_f$.
Price Decrease: If price level decreases (say $P = 2$), nominal wage adjusts to 20 ($W = 20$; $W/P = 10$); output remains at $Y_f$.

Short Run Equilibrium: Occurs at the intersection of aggregate demand and short-run aggregate supply curves.
- Produces output at $Y_f$ but can occur at different price levels.
Long Run Equilibrium: A state where both labor and goods markets are in equilibrium at the full employment output level.

Demand Shock: Shifts the aggregate demand curve - can be positive or negative, leading to necessary policy responses:
- Positive: Run contractionary policies to decrease demand.
- Negative: Run expansionary policies to stimulate demand.
Supply Shock: More complicated; positive shocks increase output and decrease inflation, while negative shocks cause the opposite.
- Responses to negative shocks include contracting demand (focusing on inflation) or expanding demand (focusing on output).

Inflation Control vs. Unemployment: Policymakers face trade-offs between rising inflation and rising unemployment during shocks.
Counteracting Inflation: The experiencing of high inflation and low output will often necessitate contractionary policies.
- Failure to act may lead to prolonged economic hardship.
Expectations and Economic Behavior: Inflation expectations can self-fulfill and accelerate; managing these is crucial to avoid unstable economic conditions.

1970s Inflation: A notable example when policymakers had to act decisively to manage expectations during high inflation and unemployment rates, resulting in severe recession.
Modern Policy Goals: Achieving a 'soft landing' where the economy can return to full employment without high inflation rates is key, particularly following demand or supply shocks.