Aggregate Supply AD/AS Model Continued

Aggregate Supply Curve Aggregate-supply curve (AS)- how supply of goods & services for the entire economy changes with inflation quantity of goods & services all firms produce at each price level AS1 Price Level Real GDP AD1 AD2 Gov’t ↓ Taxes => consumer income ↑ C ↑ => AD ↑ => R-GDP ↑ -------------------- ------------------ P2 Y2 E2 --------------- P1 Y1 E1 AD = C + I + G + NX

Different Shapes of AS Curves Worksheet Different Shapes of AS Curves Px Level Px Level Px Level AS AS AS Real GDP Real GDP Real GDP

Aggregate Supply Curve Aggregate-supply curve (AS)- how supply of goods & services for the entire economy changes with inflation Short run curve (SRAS) is upward sloping Long Run curve (LRAS) is vertical

Determinants of Real GDP In long run, economy’s output depends on quantity of: Labor Capital, Natural resources Technology In long run, Price level does not affect these variables Price Level is related only to Quantity of Money

Natural Rate of Output Full potential output or Full-employment output Definition: Level of Real GDP economy achieves in long run at full-employment (full potential output) LRAS is vertical at level of “natural rate of output” Also called: Full potential output or Full-employment output Conditions: On PPF curve & at full employment

Long-Run AS Curve Real Output Does NOT Change! Inflation Doubles: Price Inflation Doubles: Real Output Does NOT Change! Level LRAS P A change in price level P2 Does NOT affect Qty of goods/services supplied Natural rate Real GDP of output Full Employment Output

Why is the Short Run AS Curve upward sloping? 2 Primary Theories: Sticky-Wage Theory Sticky-Price Theory (you can ignore 3rd theory in Textbook— misperceptions theory) The order of discussion in Mankiw has been changed. The “misperceptions theory” must be moved to the bottom of the list. (This may affect the entire order of presentation following this slide.)

Sticky-Wage Theory Nominal wages are slow to adjust to changing economic conditions Wages are “sticky” in short run Example: Price level falls => Nominal wages do not adjust immediately Production is now less profitable because wages are artificially high So firms reduce quantity of goods & services supplied

Sticky Wages in Action Business sign 2-year contract to pay Workers $20/ hour Price Level Suddenly rises Wages are cheap in “real dollars” Firm will increase supply

Sticky Price Theory Prices of some goods & services adjust sluggishly in response to changing economic conditions An unexpected fall in price level leaves some firms with higher-than-desired prices This depresses sales, which induces firms to supply less

AS/AD Model Review P1 ----------------- E1 Y1