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1
Aggregate Supply
CHAPTER
11
© 2003 South-Western/Thomson Learning
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Aggregate Supply in Short Run
Aggregate supply is the relationship between the price level in the economy and the aggregate output f irms are wil l ing and able to supply, with other things constant
Assumed constant along a given aggregate supply curve are
Resource pricesState of technologySet of formal and informal inst itut ions that structure production incentives
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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 abil i t ies of the adult population, andHousehold preferences for work versus leisure
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Labor and Aggregate Supply
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 wil l ing and able to work
However, the purchasing power of any given nominal wage depends on the economy’s price level
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Labor and Aggregate Supply
The higher the price level, the less any given money wage wil l purchase and the lower the price level, the more any given money wage wil l purchase
Because the price level matters, we must distinguish between the nominal wage and the real wage
Nominal wage measures the wage in current dollarsReal wage measures the wage in constant dollars dollars measured by the goods and services they wil l buy
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Real and Nominal Wages
All resource suppliers, including labor, must reach agreement based on the expected price level
Wage agreements may be either explicit or implicit
Explicit agreements would be those based on a labor contractImplicit agreements would be those based on labor market practices
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Potential Output
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
Potential output is the amount produced when there are no surprises associated with the price level
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Potential Output
Potential output can be thought of as the economy’s maximum sustainable output level, given the
Supply of resourcesState of technologyFormal and informal production incentives
Often referred to by other termsNatural rate of outputFull-employment rate of output
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Natural Rate of Unemployment
Natural rate of unemploymentThe unemployment rate that occurs when the economy is producing its potential GDPThe rate that prevails when cyclical unemployment is zeroThe number of job openings is equal to the number unemployed for fr ict ional, structural, and seasonal reasonsEstimates of the natural rate range from about 4 to 6% of the labor force
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Actual Price Higher than Expected
Since the prices of many resources are fixed for the duration of the contract, f irms welcome a price level higher than expected
Their sell ing price (thus revenue) of their products, on average, are higher than expected, while the costs of at least some of the resources remain constant f irms have an incentive in the short run to expand production beyond the economy’s potential level
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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
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Why Costs Rise
As output expands above potential GDP, the cost of producing this addit ional output increases
Addit ional workers are harder to f indSome workers may not be properly preparedThe prices of those resources purchased in markets where prices are f lexible wil l increase reflecting their increased scarcityFirms use their capital resources more intensively
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Why Costs Rise
However, because the prices of some resources are f ixed by contracts, the price level r ises faster than the per-unit production cost f irms 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
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Summary
If the price level is higher than expected, f irms have a profit incentive to increase the quantity of goods and services supplied
At higher rates of output, however, the per-unit cost of addit ional output increases
Firms wil l expand output as long as the revenue from addit ional production exceeds the cost of the production
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Actual Price Lower than Expected
Production is less attractive to f irms because the prices they receive for their output are on average lower than they expectedHowever, many of their production costs, such as the nominal wage, do not fall production is less profitable than expected f irms reduce their quantity supplied the economy’s output is below its potential
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Actual Price Lower than Expected
As a result, some workers are laid off and capital resources go unused
In this case, some costs decline when output falls below the economy’s potential
As output falls, some resources become unemployed
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Summary
If the price level is higher than expected
Firms increase the quantity supplied beyond the economy’s potentialThe per-unit cost of addit ional production increases
If the price level is lower than expected
Firms reduce output below the economy’s potential outputPrices fall more than costs
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Short-Run Aggregate Supply Curve
What what have just described can be used to trace out the short-run aggregate supply curve – SRAS
SRAS shows the relationship between the actual price level and real GDP supplied, other things constant
The short run is the period during which some resource prices are fixed by either explicit or implicit agreement
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Exhibit 1:Short-Run Aggregate Supply Curve
Pri
ce
le
ve
l
140
130
120
Potential output
0 10.0 Real GDP (trillions of dollars)
SRAS130
a
The expected price level is 130; the SRAS is based on that expected price level.
If the price level turns out to be 130 as expected, producers supply the economy’s potential level of output, $10.0 trillion.
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Exhibit 1: Short-Run Aggregate Supply Curve
Pri
ce
le
ve
l
140
130
120
Potential output
0 10.0 Real GDP (trillions of dollars)
SRAS 130
a
The short-run aggregate supply becomes steeper as output increases because resources become more costly as output increases
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Exhibit 2: Expansionary Gap
a
output
130
Potential
0 10.0 Real GDP(trillions of
dollars)
SRAS 130
Pri
ce le
vel
140
Expansionary gap
135
AD
b
10.2
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Exhibit 2: Expansionary Gap
a
output
130
Potential
0 10.0Real GDP(trillions of dollars)
SRAS 130
Pri
ce le
vel
140
SRAS 140
Expansionary gap
c
135
AD
b
10.2
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Exhibit 3: Contractionary Gap
130
Potential output
0 10.0
SRAS130
Pri
ce le
vel
a
Contractionary gap
125
9.8
d
AD
120 e
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Exhibit 3: Contractionary Gap
130
Potential output
0 10.0
SRAS130
Pri
ce le
vel
a
Contractionary gap
125
9.8
d
AD
120SRAS
120 e
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Contractionary Gap
The key to closing a contractionary gap is the flexibil i ty of wages and prices
If wages and prices are not very f lexible, they wil l not adjust very quickly to a contractionary gap shifts in the short-run aggregate supply curve may occur slowly the economy can be stuck at an output and employment level below its potential
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Long-Run Aggregate Supply
The long-run aggregate supply curve, LRAS, depends on the
supply of resources in the economylevel of technologyproduction incentives provided by the formal and informal inst itut ions of the economic system
As long as wages and prices are f lexible, the economy’s potential GDP is consistent with any price level
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Exhibit 4: Long-Run Aggregate Supply Curve
130
Potential output LRAS
0 Real GDP (trillions of dollars)
a
AD
10.0
c
AD''
120
b
AD'
140
The initial price level of 130 is determined by the intersection of AD with the long-run aggregate supply curve.
Pri
c e l
evel
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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 they tend to be sticky in the downward direction
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Wage Flexibility and Employment
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 wageThe real wage wil l fall as long as the price level increases more than the nominal wage
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Increases in Aggregate Supply
The economy’s potential output is based on the
will ingness and abil i ty of households to supply resources to f irms 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 technologyinstitut ional underpinnings of the economic system
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Exhibit 6: Change in the Supply of Resources
Pri
ce l
eve
l
10.510.00 Real GDP (trillions of dollars)
LRAS'LRAS
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'
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Supply Shocks
Supply shocks are unexpected events that change aggregate supply, sometimes only temporarily
Beneficial supply shocks increase aggregate supply; examples include
Abundant harvests that increase the supply of foodDiscoveries of natural resourcesTechnological breakthroughs that allow firms to combine resources more eff icientlySudden changes in the economic system that promote more production
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Exhibit 7: Beneficial Supply Shock
LRAS
10.00 Real GDP (trillions of dollars)
130
AD
a
SRAS130
10.2
LRAS'
125
SRAS125
b
Here, the beneficial supply shock is assumed to be a technological breakthrough, which shifts the SRAS from SRAS130 to SRAS125 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.
Pri
ce l
evel
34
Decreases in Aggregate Supply
Adverse supply shocks are sudden, unexpected events that reduce aggregate supply, again sometimes, only temporarily
Drought could reduce the supply of a variety of resourcesGovernment instabil i tyTerrorist attacks
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Exhibit 8: Adverse Supply Shock
Pri
ce
le
ve
l
LRAS
10.0
0 Real GDP (trillions of dollars)
130
SRAS130
AD
a
135
LRAS''
SRAS135
c
9.8
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 movesfrom point a to point c
