Chapter 10 aggregate supply

Chapter 10Chapter 10

Aggregate SupplyAggregate Supply

Aggregate Supply in the Short-RunAggregate Supply in the Short-Run

• Aggregate supply is the relationship between the economy’s price level and the amount of output firms are willing and able to supply.

• Along the supply curve, resource prices, the state of technology, and the set of formal and informal institutions are held constant.

Labor and Aggregate SupplyLabor and Aggregate Supply

• The most important resource in production– 70% of production cost– The quantity of labor supplied depends on the

wage• The higher the wage, the more labor supplied, OTHC

Labor and Aggregate SupplyLabor and Aggregate Supply

• The higher the price level, the less purchasing power, so the less attractive that wage is to workers.

• Nominal wage or money wage: the wage measured in dollars of the year in question; the dollar amount on your paycheck.

• Real wage: the wage measured in dollars of constant purchasing power; the wage measured in terms of the quantity of goods and services it buys.

http://www.usinflationcalculator.com/inflation/current-inflation-rates/

Potential Output and the Natural Rate Potential Output and the Natural Rate of Unemploymentof Unemployment

• Firms and resource suppliers reach an agreement based off a consensus view of the coming year.

• If the actual price= expected price level, then the economy is at potential output.– The maximum sustainable output, given current

resources, technology, and rules of the game.

Potential Output and the Natural Rate Potential Output and the Natural Rate of Unemploymentof Unemployment

• Potential Output= Natural Rate of Output= the Full-Employment rate of output

• When the economy is at potential output, then the natural rate of unemployment is met.– Cyclical unemployment = zero– The range is between 4 to 6 percent

Actual Price Level is Higher Than Actual Price Level is Higher Than ExpectedExpected

• What happens in the short-run if price level is higher than expected?– This is time period during which some resource prices

remain FIXED BY CONTRACTS.– In the short-run, firms have an incentive to increase

production beyond the economy’s potential level.– Increased per-unit production cost, meaning marginal

cost increases– Why?

• Higher prices= Higher profits

Actual Price Level is Lower Than Actual Price Level is Lower Than ExpectedExpected

• In the short-run, firms have an incentive to decrease production beyond the economy’s potential level.– Decreased per-unit production cost, meaning

marginal cost decreases– Why?

• Lower prices=Lower profits

The Short-Run Aggregate Supply Curve The Short-Run Aggregate Supply Curve (SRAS)(SRAS)

• The SRAS shows the relationship between the actual price level and real GDP supplied, OTHC.– The short-run is described as a period of time

during which some resource prices are fixed by agreements, in particular, LABOR!!

LO1

Short-Run Aggregate Supply Curve

SRAS130

Potential output

Pric

e le

vel

140

120

130

Real GDP (trillions of dollars)

0 14.0

a

The SRAS curve is based on a given expected price level, in this case, 130. Point a shows that if the actual price level equals the expected price level of 130, producers supply potential output.If the actual price level is below 130, firms supply less than potential. Output levels that fall short of the economy’s potential are shaded red; output levels that exceed the economy’s potential are shaded blue.

Exhibit 1

Closing an Expansionary GapClosing an Expansionary Gap

• The long-run is long enough that firms and resource suppliers can renegotiate all agreements based on knowledge of the actual price level.– In the long-run, no surprises about price level.


• What if aggregate demand turns out to be greater than expected?– In the short-run:

• Actual price level is greater than expected• Output exceeds the economy’s potential output

– Real GDP exceeds potential– The unemployment rate is less than its natural rate– The amount by which it exceeds potential output is the

expansionary gap.

Long-Run Adjustment When the Price Level Exceeds Expectations

Expected price level=130, SRAS130

If actual price level turns out as expected, the quantity supplied = potential output of $14 trillion.Given the AD curve, price level > expected; output exceeds potential (b); expansionary gap.In the long-run, price-level expectations and nominal wages will be revised upward. Costs will rise and the SRAS curve shifts leftward to SRAS140. Eventually, the economy will move to long-run equilibrium (c), thus closing the expansionary gap.

LO2

Exhibit 2

Potential output

Pric

e

leve

l

140

130

135

AD

SRAS130

b

Real GDP

(trillions of dollars)

0 14.0 14.2

a

SRAS140

c

LRAS


• In the long-run:– Workers will demand a higher nominal wage– Increased production costs

• Shifting the SRAS leftward

– Lower output


• Long-run equilibrium:– Expected price level=actual price level– Quantity supplied in short-run = quantity supplied

in long-run– Quantity supplied= quantity demanded

Closing an Contractionary GapClosing an Contractionary Gap

• What if aggregate demand turns out to be less than expected?– In the short-run:

• Actual price level is less than expected• Output less the economy’s potential output

– Real GDP less than potential– The unemployment rate is higher than its natural rate– The amount by which actual output falls short of potential

output is the contractionary gap.

Long-Run Adjustment When the Price Level Is Below Expectations

Actual price level < expected (intersection of AD” with SRAS130); short-run equilibrium: (d). Production below economy’s potential opens a contractionary gap.

If prices and wages are flexible enough in the long run, nominal wages will be renegotiate lower. As resource costs fall, the short-run aggregate supply curve eventually shifts rightward to SRAS120 and the economy moves to long-run equilibrium at (e), with output increasing to the potential level of $14.0 trillion.

LO2

Exhibit 3

Potential output

Pric

e

leve

l

130

120

125

AD”

SRAS130

d

Real GDP


0 14.013.8

SRAS120

e

LRAS

a

Closing an Contractionary GapClosing an Contractionary Gap

• Long run– Lower nominal wages– Lower cost of production– SRAS shifts right– Deflation– Greater output– Long-run equilibrium

Tracing Potential OutputTracing Potential Output• The long-run aggregate supply (LRAS) depends on

the supply of resources in the economy, the level of technology, and the production incentives provided by the formal and informal institutions of the economic system.

• Depends on:– Supply of resources in the economy, level of technology,

and production incentives– Long-run equilibrium:

– Output = LRAS = potential output– Price level depends on AD curve

Long-Run Aggregate Supply Curve

In the long run, when the actual price level equals the expected price level, the economy produces its potential. In the long-run, $14.0 trillion in real GDP will be supplied regardless of the actual price level. As long as wages and prices are flexible, the economy’s potential GDP is consistent with any price level. Thus, shifts of the aggregate demand curve will, in the long-run, not affect potential output. The long-run aggregate supply curve, LRAS, is a vertical line at potential GDP.

LO2

Exhibit 4P

rice

leve

l

140

120

130

AD”

Real GDP


0 14.0

Potential outputLRAS

AD

AD’

b

a

c

Wage Flexibility and EmploymentWage Flexibility and Employment Expansionary gap

– Labor shortage– Higher nominal wage– Higher price level

Contractionary gap– Nominal wages = “sticky” downward– Slow to close

Shifts of Aggregate Supply CurveShifts of Aggregate Supply Curve

• Aggregate supply increases, LRAS– Increased quantity and quality of labor and other

resources– Institutional changes– Does so gradually

Effect of a Gradual Increase in Resources on Aggregate Supply

A gradual increase in the supply of resources increases the potential GDP – in this case, from $14.0 trillion to $14.5 trillion.

The long-run aggregate supply curve shifts to the right.

LO3

Exhibit 5

Pric

e le

vel

LRAS LRAS’

Real GDP


0 14.514.0

Shifts of the Aggregate Supply Curve

Supply shocks Unexpected events

Beneficial supply shocks Increase aggregate supply (SRAS,

(SRAS, LRAS) Abundant harvests Discoveries of natural resources Technological breakthroughs Sudden changes in economic system;

tax cuts Higher output; lower price level

Effects of a Beneficial Supply Shock on

Aggregate SupplyGiven the AD curve, a beneficial supply shock that has a lasting effect, such as a breakthrough in technology, will permanently shift both the short-run aggregate supply curve and the long-run aggregate supply curve, or potential output. A beneficial supply shock lowers the price level and increases output, as reflected by the change in equilibrium from a to b.

A temporary beneficial supply shock (an unusually favorable growing season), will shift the AS curves only temporarily. If the next growing season returns to normal, the AS curves will return to their original equilibrium position at a.

Exhibit 6LRAS LRAS’

Real GDP


0 14.214.0

Pric

e

leve

l

130

125

AD”

SRAS130

SRAS125

b

a

Shifts of the Aggregate Shifts of the Aggregate Supply CurveSupply Curve

Adverse supply shocks Decrease aggregate supply

(SRAS, LRAS) A drought Overthrow of government Terrorist attacks

Stagflation Lower output Higher price level

Effects of an Adverse Supply Shock on

Aggregate Supply

Given the AD curve, an adverse supply shock, such as an increased threat of terrorism, shifts the short-run and long-run aggregate supply curves to the left, increasing the price level and reducing real GDP, a movement called stagflation. This change is shown by the move in equilibrium from a to c.

If the shock is just temporary, the shift of the aggregate supply curves will be temporary.

LO3

Exhibit 7

LRASLRAS”

Real GDP


0 14.013.8

Pric

e

leve

l

130

125

AD”

SRAS130

SRAS135

c

a

Chapter 10 aggregate supply

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