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1 Aggregate Supply Chapter 26 © 2006 Thomson/South-Western.

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1 1 Aggregate Supply Chapter 26 © 2006 Thomson/South-Western

2 2 Aggregate Supply in the Short Run  Aggregate supply is the relationship between the price level in the economy and the aggregate output firms are willing and able to supply, with other things constant  Assumed constant along a given aggregate supply curve are  Resource prices  State of technology  Set of formal and informal institutions that structure production incentives

3 3 Labor and Aggregate Supply  Labor is the most important resource, accounting for about 70% of production costs  The supply of labor in an economy depends on  The size and abilities of the adult population  Household preferences for work versus leisure  Along a given labor supply curve, the quantity of labor depends on the wage rate: the higher the wage, other things constant, the more people are willing and able to work

4 4 Labor and Aggregate Supply  The higher the price level, the less any given money wage will purchase  The lower the price level, the more any given money wage will purchase

5 5 Real and Nominal Wages  Real wage: the wage measured in current dollars; the dollar amount on a paycheck  Nominal wage: the wage measured in dollars of constant purchasing power; the wage measured in terms of the quantity of goods and services it will buy

6 6 Real and Nominal Wages  Workers and employers care more about the real wage than about the nominal wage  It is uncertain what price level will prevail during the life of the wage agreement: labor contracts must be negotiated in terms of nominal wages  Resource prices that are set by long-term contracts remain in force for extended periods

7 7 Real and Nominal Wages  By implication, all resource suppliers, including labor, must reach agreement based on the expected price level  Wage agreements may be either explicit or implicit  Explicit agreements are based on a labor contract  Implicit agreements are based on labor market practices

8 8 Potential Output  Potential output: The economy’s maximum sustainable output, given the supply of resources, technology, and production incentives; the output level when there are no surprises about the price level  Firms and resource suppliers expect a certain price level to prevail in the economy during the year  If these price-level expectations are realized, the agreed-upon nominal wage translates into the expected real wage  When the actual price level turns out as expected, the resulting level of output is referred to as the economy’s potential output

9 9 Potential Output  Potential output can be thought of as the economy’s maximum sustainable output level, given the  Supply of resources  State of technology  Formal and informal production incentives  Often referred to by other terms such as the natural rate of output or the full- employment rate of output

10 10 Natural Rate of Unemployment  Natural rate of unemployment  The unemployment rate that occurs when the economy is producing its potential GDP  The rate that prevails when cyclical unemployment is zero  The number of job openings is equal to the number unemployed for frictional, structural, and seasonal reasons  Estimates of the natural rate range from about 4 to 6% of the labor force

11 11 Actual Price Higher than Expected  The short run is a period during which many resource prices remain fixed by contract  Since the prices of many resources are fixed for the duration of the contract, firms welcome a price level is higher than expected  Their selling price (thus revenue) of their products, on average, are higher than expected, while the costs of at least some of the resources remain constant  firms have an incentive in the short run to expand production beyond the economy’s potential level

12 12 Actual Price Higher than Expected  Even in an economy producing its potential output, there is some unemployed labor and unused production capacity  Potential GDP can be thought of as the economy’s normal capacity  Firms and workers are able, in the short run, to push output beyond the economy’s potential

13 13 Short-Run Period  Short run: a period during which some resource prices, especially those for labor, are fixed by explicit or implicit agreements

14 14 Why Costs Rise  As output expands above potential GDP, the cost of producing this additional output increases  Additional workers are harder to find  Some workers may not be properly prepared  The prices of those resources purchased in markets where prices are flexible will increase, reflecting their increased scarcity  Firms use their capital resources more intensively

15 15 Why Costs Rise  Because the prices of some resources are fixed by contracts, the price level rises faster than the per-unit production cost: firms find it profitable to increase the quantity supplied  When the actual price level exceeds the expected price level, the real value of an agreed-upon nominal wage declines  Workers might be willing to increase the quantity of labor they supply is that the labor agreement might require this

16 16 Summary  If the price level is higher than expected, firms have a profit incentive to increase the quantity of goods and services supplied  At higher rates of output, however, the per-unit cost of additional output increases  Firms will expand output as long as the revenue from additional production exceeds the cost of the production

17 17 Actual Price Lower than Expected  Production is less attractive to firms because the prices they receive for their output are on average lower than they expected  Many of their production costs, such as the nominal wage, do not fall,  production is less profitable than expected  firms reduce their quantity supplied  the economy’s output is below its potential  some workers are laid off and capital resources go unused  some costs decline when output falls below the economy’s potential  As output falls, some resources become unemployed

18 18 Summary  If the price level is higher than expected:  Firms increase the quantity supplied beyond the economy’s potential  The per-unit cost of additional production increases  If the price level is lower than expected:  Firms reduce output below the economy’s potential output  Prices fall more than costs  The combination of these two changes implies there is a direct relationship in the short run between actual price level and real GDP supplied

19 19 Exhibit 1:Short-Run Aggregate Supply Curve 140 130 120 Potential output 0 12.0 Real GDP (trillions of dollars) SRAS 130 a  The short run aggregate supply curve, SRAS, shows the relationship between the actual price level and real GDP supplied, other things constant  If the price level turns out to be 130 as expected, producers supply the economy’s potential level of output, $12.0 trillion  If the economy produces at its potential, unemployment is at the natural rate.  Output levels that fall short of the economy’s potential are shaded red; output levels that exceed the economy’s potential are shaded blue. Price level

20 20 From the Short Run to the Long Run  Short-run equilibrium: the price level and real GDP that occur when the aggregate demand curve intersects the short-run aggregate supply curve  Expansionary gap: The amount by which output in the short run exceeds the economy's potential output

21 21 Long Run  In macroeconomics, a period during which wage contracts and resource price agreements can be renegotiated; there are no surprises about the economy’s actual price level  Long-run equilibrium: The price level and real GDP that occurs when (1) the actual price level equals the expected price level, (2) real GDP supplied equals potential output, and (3) real GDP supplied equals real GDP demanded

22 22 Exhibit 2: Short-Run Equilibrium When the Price Level Exceeds Expectations a output 130 Potential 0 12.0 Real GDP (trillions of dollars) SRAS 130 Price level 140 SRAS 140 Expansionary gap c 135 AD b 12.2  The equilibrium price level and real GDP depend on aggregate demand  What if aggregate demand turns out to be greater than expected, as shown by AD  Point b is the short-run equilibrium, reflecting a price level of 135 and a real GDP of $12.2 trillion  The actual price level is higher than expected and the level of output exceeds the economy’s potential  The amount by which short- run equilibrium output exceeds the economy’s potential is often referred to as the expansionary gap

23 23 Exhibit 2: Short-Run Equilibrium When the Price Level Exceeds Expectations a output 130 Potential 0 12.0 Real GDP (trillions of dollars) SRAS 130 Price level 140 SRAS 140 Expansionary gap c 135 AD b 12.2  When real GDP exceeds potential output, actual unemployment rate is below its natural rate.  Because the price level prevailing in the short run exceeds the expected price level, the real wage is lower than expected  What happens in the long run?  Nominal wages increase, firms’ production costs increase, and the short-run aggregate supply curve shifts leftward to SRAS 140 at point c, where the actual price level equals the expected price level  Actual output can exceed the economy’s potential in the short run, but not in the long run

24 24 Contractionary Gap  Contractionary gap: the amount by which actual output in the short run falls short of the economy’s potential output  If wages and prices are not very flexible, they will not adjust very quickly to a contractionary gap  Shifts in the short-run aggregate supply curve may occur slowly

25 25 Exhibit 3: Short-Run Equilibrium When the Price Level is Below Expectations  Again, begin with an expected price level of 130.  If the AD curve intersects the short-run AS curve to the left of potential output (at point d), production is less than the economy’s potential  Amount by which actual output falls short of potential GDP is called the contractionary gap  Unemployment exceeds the natural rate  The lower-than-expected price level translates into a higher real wage in the short run 130 Potential output 0 12.0 SRAS 130 Price level a Contractionary gap 125 11.8 d AD 120 e Real GDP (trillions of dollars)

26 26 Exhibit 3: Short-Run Equilibrium When the Price Level is Below Expectations  What happens in the long run?  Employers are no longer willing to pay as high a nominal wage; with the unemployment rate higher than the natural rate, more workers are competing for jobs, putting downward pressure on the nominal wage; costs of production decline  The SRAS curve shifts rightward until it intersects the aggregate demand curve, where the economy produces its potential output at SRAS 120  The economy will reach long- run equilibrium at point e 130 Potential output 0 12.0 SRAS 130 Price level a Contractionary gap 125 11.8 d AD 120 e SRAS 120 Real GDP (trillions of dollars)

27 27 Long-Run Aggregate Supply  The long-run aggregate supply curve, LRAS, depends on the  supply of resources in the economy  level of technology  production incentives provided by the formal and informal institutions of the economic system  As long as wages and prices are flexible, the economy’s potential GDP is consistent with any price level

28 28 Exhibit 4: Long-Run Aggregate Supply Curve  A decline aggregate demand from AD to AD'' will, in the long run, lead to a fall in the price level with no change in output  If the aggregate demand curve shifts out to AD', then in the long run the equilibrium price level will increase to 140, where the same level of economy’s potential GDP is realized

29 29 Wage Flexibility and Employment  What evidence is there that a vertical line drawn at the economy’s potential GDP can depict the long-run aggregate supply curve?  Except during the Great Depression, unemployment over the last century, while varying from year to year, has typically returned to what would be viewed as a natural rate of unemployment

30 30 Wage Flexibility and Employment  An expansionary gap creates a labor shortage that eventually results in a higher nominal wage and a higher price level  A contractionary gap does not necessarily generate enough downward pressure to lower the nominal wage, e.g., that is, nominal wages are slow to adjust to high unemployment

31 31 Wage Flexibility and Employment  Since nominal wages fall slowly, if at all, the natural supply-side adjustment needed to close a contractionary gap may take so long as to seem ineffective  However, an actual decline in the nominal wage is not necessary to close a contractionary gap  All that is needed is a fall in the real wage  The real wage will fall as long as the price level increases more than the nominal wage

32 32 Exhibit 5: U.S. Output Gaps Measures Actual Output Minus Potential Output as Percentage of Potential Output

33 33 Increases in Aggregate Supply  The economy’s potential output is based on the  willingness and ability of households to supply resources to firms which can be caused by a change  in the size, composition, or quality of the labor force  in household preferences for labor versus leisure  level of technology  institutional underpinnings of the economic system

34 34 Exhibit 6: Effect of a Gradual Increase in Resources on Aggregate Supply A gradual increase in the supply of resources increases the potential level of real GDP – the long run aggregate supply curve shifts from LRAS to LRAS'

35 35 Supply Shocks  Supply shocks are unexpected events that change aggregate supply, sometimes only temporarily  Beneficial supply shocks increase aggregate demand; examples include  Abundant harvests that increase the supply of food  Discoveries of natural resources  Technological breakthroughs that allow firms to combine resources more efficiently  Sudden changes in the economic system that promote more production

36 36 Exhibit 7: Effects of a Beneficial Supply Shock on Aggregate Supply LRAS 12.0 0 Real GDP (trillions of dollars) 130 AD a SRAS 130 12.2 LRAS' 125 SRAS 125 b  Here, the beneficial supply shock is assumed to be a technological breakthrough, which shifts the SRAS from SRAS 130 to SRAS 125 and the long-run aggregate supply curve from LRAS to LRAS´  Thus, for a given aggregate demand curve, a beneficial supply shock leads to an increase in output and a decrease in the price level Price level

37 37 Decreases in Aggregate Supply  Adverse supply shocks: sudden, unexpected events that reduce aggregate supply, again sometimes, only temporarily  Drought could reduce the supply of a variety of resources  Government instability  Terrorist attacks

38 38 Exhibit 8: Effects of an Adverse Supply Shock on Aggregate Supply  The adverse supply is shown as the leftward shift of both the short and long-run aggregate supply curves with the result that the price level increases and the level of output declines  Stagflation as equilibrium moves from point a to point c


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