Aggregate Supply Chapter 9-2

Aggregate Supply The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output.

Aggregate Supply Curve Aggregate Supply is the amount of real GDP that will be made available by sellers at various price levels. Aggregate Supply looks different in the Long Run and the Short Run: In the Long Run, classical economists assume the economy operates at full employment (maximum output), independent of the price level. In the Short Run, businesses will increase supply if the price level increases. 3

Positive Relationship There is a positive relationship in the short run between price level and the quantity of aggregate output supplied.

The Aggregate Supply Curves The Slope of the Short-Run Aggregate Supply (SAS) Curve The SAS curve is upward sloping because of: Auction markets Prices are determined by demand and supply and supply curves are upward sloping Posted price markets Also called quantity-adjusting markets, markets in which firms respond to changes in demand by changing production instead of changing their prices Firms tend to increase their markup when demand increases

Shifts in the SAS Curve Price level SAS1 SAS0 SAS2 Real output Shifts in the SAS are caused by changes in: Input prices Productivity Import prices Excise and sales taxes When production costs increase, the SAS curve shifts up In general: %Δ in price level = %Δ in wages – %Δ in productivity Price level SAS1 SAS0 SAS2 Real output

The Long-Run Aggregate Supply Curve The long-run aggregate supply (LAS) curve shows the long-run relationship between output and the price level The position of the LAS curve depends on potential output which is the amount of goods and services an economy can produce when both capital and labor are fully employed The LAS curve is vertical because potential output is unaffected by the price level

The LAS Curve Price level Potential output is assumed to be in the middle of a range bounded by high and low levels of potential output LAS When resources are over- utilized (point C), factor prices may be bid up and the SAS shifts up SAS Overutilized resources C When resources are under- utilized (point A), factor prices may decrease and SAS shifts down B Underutilized resources A Real output Low-level potential output High-level potential output

Low-level potential output High-level potential output LAS Estimating potential output is inexact, so it is assumed to be the middle of a range bounded by a high level of potential output and a low level of potential output. When resources are over-utilized (point C), factor prices may be bid up and the SAS shifts up. C The relationship between potential and actual output – where the economy is on SAS – determines shifts in SAS. B A SAS Price Level When resources are under-utilized (point A), factor prices may decrease and SAS shifts down. Underutilized resources Overutilized resources Real output Low-level potential output High-level potential output When LAS = SAS (point B), there is no pressure for prices to rise or fall.

Increases in the LAS are caused by increases in: Capital Resources Shifts in the LAS Curve Increases in the LAS are caused by increases in: Capital Resources Growth-compatible institutions Technology Entrepreneurship Price level LAS0 LAS1 LAS2 Real output

LRAS The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible Do you remember the debate between Classical and Keynes?

A Range for Potential Output and the LAS Curve The position of the long-run aggregate supply curve is determined by potential output. Potential output – the amount of goods and services an economy can produce when both labor and capital are fully employed. Was this in your textbook?

Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP , because in the long run an increase in the aggregate price level has no effect on the quantity of aggregate output supplied.

Actual and Potential Output The above graph shows the performance of actual and potential output in the United States from 1989 to 2004. The black line shows estimates of U.S. potential output, produced by the Congressional Budget Office, and the blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggregate output fell below potential output, and the green-shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000. Actual aggregate output was significantly above potential output in the boom of the late 1990s.

Short-Run Equilibrium in the AD/AS Model Price level Short-run equilibrium is where the SAS and AD curves intersect and point E is short-run equilibrium A shift in the aggregate demand curve to the right changes equilibrium from E to F, increasing output from Y0 to Y1 and increasing price level from P0 to P1 SAS P1 P0 F AD1 E AD0 Real output Y0 Y1

Short-Run Equilibrium in the AD/AS Model Price level A shift up in the short-run aggregate supply curve changes equilibrium from E to G, decreasing output from Y0 to Y2 and increasing price level from P0 to P2 SAS1 P2 SAS0 P0 G E AD Real output Y2 Y0

Long-Run Equilibrium in the AD/AS Model Long-run equilibrium is where the LAS and AD curves intersect Price level LAS A shift in the aggregate demand curve changes equilibrium from E to H, increasing the price level from P0 to P1 but leaving output unchanged H P1 E P0 AD1 AD0 Real output YP

Application: A Recessionary Gap in the AD/AS Model Price level A recessionary gap is the amount by which equilibrium output is below potential output SAS1 LAS At point A, some resources are unemployed and the recessionary gap is YP – Y1 SAS0 A P1 Eventually wages and prices decrease and SAS shifts down to return the economy to a long and short-run equilibrium at E E P0 Gap AD0 Y1 YP Real output

Application: An Inflationary Gap in the AD/AS Model Price level An inflationary gap is the amount by which equilibrium output is above potential output LAS At point B, resources are being used beyond their potential and the inflationary gap is Y2 – YP SAS0 E P0 SAS2 B Eventually wages and prices increase and SAS shifts to return the economy to a long and short-run equilibrium at E P2 Gap AD0 YP Y2 Real output

From the Short Run to the Long Run Leftward Shift of the Short-run Aggregate Supply Curve The initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2.

From the Short Run to the Long Run Rightward Shift of the Short-run Aggregate Supply Curve At the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. This reflects the fact that the short-run aggregate supply curve has shifted to the right, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve.

Aggregate Demand Policy A primary reason for government policy makers’ interest in the AS/AD model is that monetary or fiscal policy shifts the AD curve Monetary policy involves the Federal Reserve Bank changing the money supply and interest rates Fiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the economy

Application: Expansionary Fiscal Policy in the AD/AS Model Price level If the economy is at point A, there is a recessionary gap equal to YP – Y0 LAS The appropriate fiscal policy is to increase government spending and/or decrease taxes P1 E P0 A AD shifts to the right and output returns to potential output YP and prices increase to P1 AD1 Gap AD0 Y0 YP Real output

Application: Contractionary Fiscal Policy in the AD/AS Model Price level LAS If the economy is point B, there is an inflationary gap Y2 – YP The appropriate fiscal policy is to decrease government spending and/or increase taxes B P2 P1 AD shifts to the left, output returns to potential output YP and inflation is prevented E AD0 Gap AD2 YP Y2 Real output

Limitations of the AS/AD Model The AS/AD model assumes away many possible feedback effects that can significantly affect the macroeconomy and lead to quite different conclusions Implementing fiscal policy through changing taxes and government spending is a slow legislative process There is no guarantee that government will do what economists say is necessary

Limitations of the AS/AD Model Potential output (the level of output that the economy is capable of producing without generating inflation) is difficult to estimate We do have ways to get a rough idea of where it is There are many other possible interrelationships in the economy that the model does not take into account The aggregate economy can become dynamically unstable, so a shock can set in motion changes that will not automatically be self-correcting

Limitations of the AS/AD Model There are two ways to think about the effectiveness of fiscal policy: in the model and in reality The effectiveness of fiscal policy depends on the government’s ability to perceive and to react appropriately to a problem Countercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycle Fine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or potential level of income

Chapter Summary The key idea of the Keynesian AS/AD model is that in the short run the economy can deviate from potential output The AS/AD model consists of the aggregate demand curve, and the short-run aggregate supply curve, and the long-run aggregate supply curve Short-run equilibrium is where the SAS and AD curves intersect; Long-run equilibrium is where the AD and LAS curves intersect Aggregate demand management policy attempts to influence the level of output in the economy

Chapter Summary Fiscal policy works by providing a deliberate countershock to offset unexpected shocks to the economy Macroeconomic policy is difficult to conduct because: Implementing fiscal policy is a slow process We don’t really know where potential output is There are interrelationships not included in the model The economy can become dynamically unstable