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The Theory of Aggregate Supply
Short Run Aggregate Supply Curve
Learning Objectives
• Understand the determinants of output.• Understand how output is distributed.• Learn how to derive the short run aggregate
supply curve.• Learn how to shift the short run aggregate
supply curve.• Learn how macroeconomic policy affects
the real goods market and the labor market.
Aggregate Supply
• Aggregate supply: The amount of output supplied by firms in the economy at any given price level.
• Aggregate supply curve: The relation between the price level and the total amount of output that firms supply.
Aggregate Supply: Short Run• In the long-run, the aggregate supply curve is
vertical.– Prices are completely flexible: Output is fixed.
• In the short-run, the aggregate supply curve may be horizontal or upward sloping.– Horizontal aggregate supply curves exist when
prices are completely inflexible and output is totally flexible.
– Upward sloping aggregate supply curves imply both price and output flexibility.
The Short Run Aggregate Supply Curve: Derivation
• Assumptions:– The nominal wage is fixed at a particular value.– The real wage changes as the price level
changes, rising as the price level falls and falling as the price level rises.
– Worker behavior is ignored for now.
Production: Definitions
• Production is the activity of transforming resources into finished goods.
• Technology is a method for transforming resources into finished goods.
• Factors of production are inputs used in the production process such as labor and capital.
Determining Total Output
• An economy’s output of goods and services, GDP, depends on:– The quantity and quality of inputs or factors
of production.– The economy’s production function.
Factors of Production
• Factors of production are the inputs used to produce goods and services.
• The two most important factors of production are labor (L) and capital (K).
Production Function
• The production function is a relationship between the quantities of factors of production employed by all firms in the economy and the total production of real output by those firms, given the technology available.
• Y = F(K, L)
The Production Function
Y = F(L,K)
L
Y
Y = F(L,K) says that the total amount of real output is a function of the amount of labor employed by all firms in the economy.
Capital is assumed to be fixed.
0
The Production Function
• The production function is concave.– This means that the production function’s slope
rises at a decreasing rate.• For every increase in labor, output increases by
smaller amounts.
– The production function is drawn this way because we are assuming the law of diminishing returns causes each additional unit of labor to produce less output.
The Marginal Product of Labor
• The slope of the production function is /\Y//\L or the additional amount of output produced when one more worker is added.
• Another name for the change in output divided by the change in labor is the marginal product of labor (MPL).
• Since the production function increases at a decreasing rate, MPL must slope down.
The Marginal Product of Labor
L
L
Y
MPL
Y=F(L)
MPL
/\Y1
/\L1
/\L2
/\Y2
Note that the change in L is the same butthe change in Y is smaller at the higherlevel of L, reflecting the impact of theLaw of Diminishing Returns.
Note that the marginal product of laboris drawn sloping down, reflecting the factthat as more workers are added themarginal product of the next workerdecreases.
0
0
Distribution of Income
• The distribution of national income is determined by factor prices.
• Factor prices are the amounts paid to the factors of production.
• How does a competitive firm decide how much to pay its factors of production?
Profits and the Competitive Firm
• A profit maximizing, competitive firm takes the product price and the factor prices as given and chooses the amounts of output, labor and capital that maximize profits.– How does the firm choose?
Profit Maximizing Math
• Labor Demand /\Profit = /\Revenue - /\Cost /\Profit = (P x MPL) - w = 0
P x MPL = w
MPL = w/PLabor Demand
Demand for Labor
• w = P x MPL
– A profit-maximizing competitive firm hires labor up to the point where the nominal wage just equals the value of the marginal product of labor.
• w/P = MPL
– A profit-maximizing competitive firm hires labor up to the point where the real wage just equals the marginal product of labor.
Alternative Demand for Labor Schedules
w/P
W
L
L
MPL = LD
P x MPL = LD(P)
A profit maximizing firm employs laborto the point where the VMP is equal tothe nominal or money wage.
A profit maximizing firm employs laborto the point where the marginal productof labor is equal to the real wage.
0
0
Demand for Labor
• The value of the marginal product of labor schedule for a perfectly competitive firm is that firm’s labor demand schedule.– It shows how many units of labor the firm demands at
any given nominal wage w.
• The marginal product of labor schedule for a perfectly competitive firm is that firm’s labor demand schedule.– It shows how many units of labor the firm demands at
any given real wage w/P.
Nominal Wages and Real Wages?
• The nominal wage is the money wage paid.
• The real wage in the nominal wage adjusted by the price level as measured by the average price of goods and services.– The real wage reflects the true purchasing power
of the worker’s income.
Putting It All Together
Deriving Aggregate Supply
What Does All This Mean for Aggregate Supply?
• Aggregate supply is the total quantity of goods and services produced by an economy.
• The aggregate supply curve is a schedule relating the total supply of all goods and services in the economy to the general price level.
• What does the aggregate supply curve look like?
The Model Components
• The production function relates output produced to labor employed.
• Labor employed is determined by labor demand.
• The balancing line transfers output from the vertical axis to the horizontal.
• Aggregate supply will show the relationship between output and the price level.
Y
L
Y
Y
Y
P
L
w/P
Y=F(L)
Production FunctionBalancing Line
Labor MarketAggregate Supply
0
0
0
0
LD
Sticky Wage Model
• When the nominal wage is set, a rise in the price level lowers the real wage.
• The lower real wage encourages firms to hire more labor.
• The additional labor produces more output.
• Y = Y + (P - Pe) > 0– Output deviates from its natural rate when the price
level deviates from the expected price level.
Aggregate Supply Curve with Sticky Wages
• Assumptions:– Workers and firms bargain over and agree on the
nominal wage before they know what the price level will be when the agreement takes effect.
– After the nominal wage is set and before workers are hired, firms learn the price level. Workers do not.
– Employment is determined by the labor demanded by firms.
Deriving Aggregate Supply
• Let the price level be P1.
– At the price level P1, the real wage is w/P1.
– At the wage w/P1, firms are willing to hire L1 workers.
• Given L1 workers, the production function shows that output equals Y1.
• The combination Y1, P1 is one point on the aggregate supply curve.
Y Y
Y
Y
L
P w/PL1
Y1
Y=F(L)
P1
Y1
L1 Y1L0
0
0
0
w/P1.
LD
Deriving Aggregate Supply
• Let the price level be P2.
– At the price level P2, the real wage is w/P2.
– At the wage w/P2, firms are willing to hire L2 workers.
• Given L2 workers, the production function shows that output equals Y2.
• The combination Y2, P2 is another point on the aggregate supply curve.
Y Y
Y
Y
L
P w/P
Y1
w/P1
Y=F(L)
P1
Y1
Y1L
P2
0
0
0
0
w/P2
L2
AS
.
.
LD
L1
Aggregate Supply Curve
• The aggregate supply curve is upward sloping because as the real wage decreases firms are willing to employ more workers.– As more workers are employed, output
increases.
Determination of the Equilibrium Real Wage
Equilibrium Real Wage
• The equilibrium real wage is the real wage rate for the point at which the labor supply and demand curves intersect, so there is no pressure for change.
Labor Supply
LS
w/P
0
LS
LS
w/P
Individuals choose how many hoursto work.
As the real wage rises, leisure becomesmore expensive relative to the goodsand services available, so people chooseto work more.
As the real wage falls, leisure becomesless expensive relative to the goods andservices available, so people choose towork less.
Equilibrium: The Labor Market
w/P
L
LS
At w/P labor demand justequals labor supply.
The labor market clears.
L0
w/P
LD
Labor Market Changes and Aggregate Supply
• Factors that shift labor demand and labor supply also cause cause fluctuations in the level of output.– Labor demand shifts with changes in
technology/productivity.– Labor supply shifts with changes in taxes,
preferences, and wealth.
Change in Technology
• New technology increases productivity.– The production function shifts up.– The labor demand curve shifts to the right.
• The increase in demand for labor increases the real wage, causing an increase in labor supply along the labor supply curve.
• Aggregate supply increases.– At the price level, P1, more output is produced.
Y
L
Y
Y
Y
Pw/P
Y1=F(L)
LS
L1
Y1
Y1L
w1/P1
0
0
0
0
Y2=F(L)Y2
Y2
AS1
AS2
1
2
1
2
w2/P1
LD1
LD2
P1
Factors that Shift Labor Supply
• Taxes:– Taxes reduce labor supply by lowering the
wage received by households.• An increase in the tax rate shifts the labor supply
curve to the left.• The decrease in labor supply increases the
nominal wage, causing firms to move up along the labor demand curve and hire fewer workers.
• Equilibrium employment and aggregate supply decrease.
Y
L
Y
Y
Y
P
L
w/P
Y=F(L)
LS2
P1
L2
Y2
Y2
Y2AS2
w/P1
0
0 0
0
LD
w/P1
L1
Y1
Y1
Y1
LS1
AS1
Factors that Shift Labor Supply
• Taxes:– Decreases in taxes increase the labor supply by
raising the wage received by households.• A decrease in the tax rate shifts the labor supply
curve to the right.• The increase in labor supply decreases the
nominal wage, causing firms to move down along the labor demand curve and hire more workers.
• Equilibrium employment and aggregate supply increase.
• Preferences– A change in worker preferences with respect to
labor supply shifts the labor supply curve.• If workers decide to work more, the labor supply
curve shifts to the right.• The increase in labor supply decreases the
nominal wage, causing firms to move down along the labor demand curve and hire more workers.
• Equilibrium employment and aggregate supply increase.
Factors that Shift Labor Supply
Y Y
Y
Y
L
P w/P
Y1
LS1
Y=F(L)
L1 L2Y1 Y2
L0
0
0
0
w1/P1
LS2
Y2
w2/P1
LD
Y1 Y2
P1
AS1AS2
Factors that Shift Labor Supply
• Wealth:– An increase in wealth reduces labor supply by
decreasing the need to work.• An increase in the wealth shifts the labor supply
curve to the left.
• A decrease in the wealth shifts the labor supply curve to the right.
– However, as the USA has become wealthier, labor supply has not decreased. Why?
Labor Supply and Wealth
• As people become wealthier, they have an incentive to consume more leisure. – This is known as the wealth effect.
• But, as the real wage rises, people have an incentive to work more. – This is known as the substitution effect.
• The employment rate has been roughly constant because the substitution effect and wealth effects balance out over time
Expansionary Government Policy
A Short-Run Analysis
Equilibrium
AD0
0
P
Y
B
Yfemp
SRAS0(W0,LD0)
LRAS
At point B, the model is in long-run equilibrium and short-runequilibrium.
AD = SRAS = LRAS
The equilibrium price level is P0
and the full employment equilibrium output is Yfemp
P0
Fiscal or Monetary Expansion
AD1
AD0
0
P
Y
B
Yfemp Y1 Y3
L
SRAS0(W0,LD0)
P0
Higher planned spending by thegovernment or increases in themoney supply shift AD0 to AD1.
Y3 is the level of output that wouldbe reached if the price leveldid not rise.
At point L, output increases bythe full amount of the simplemultiplier.
Fiscal or Monetary Expansion
AD1
AD0
0
P
Y
B
C
Yfemp Y1 Y3
L
SRAS0(W0,LD0)
P1
P0
Equilibrium occurs at point C,where both the price level and output have risen.
At point C, the real wage hasfallen, so firms are willing to hiremore workers.
Fiscal or Monetary Expansion
AD1
AD0
0
P
Y
B
C
D
Yfemp Y1
L
SRAS1(W1,LD0)
SRAS0(W0,LD0)
P2
P1
P0
As workers realize that the real wagehas fallen, they demand a highernominal wage.
The increase in the nominal wage causes the SRAS to shift left.
A new equilibrium is established at D.
Fiscal or Monetary Expansion
AD1
AD0
0
P
Y
B
C
D
E
Yfemp Y1
L
SRAS3(W3,LD0)SRAS1(W1,LD0)
SRAS0(W0,LD0)
P2
P3
P1
P0
At point D, the real wage has fallenagain, causing workers to demanda higher nominal wage.
As nominal wages increase, the SRASshifts left.
Fiscal or Monetary Expansion
AD1
AD0
0
P
Y
B
C
D
E
Yfemp Y1
L
SRAS3(W3,LD0)SRAS1(W1,LD0)
SRAS0(W0,LD0)
P2
P3
P1
P0
Long-run equilibrium is restored atpoint E.
At this point, the nominal wage has risen such that W3/P3 = W0/P0.
Long Run Aggregate Supply
• The long-run aggregate supply curve is a vertical line drawn at the natural level of real GDP.– It shows that equilibrium in the labor market
can be achieved at many different price levels but only a single level of output.
– Long-run equilibrium occurs when labor input is the amount voluntarily supplied and demanded at the equilibrium real wage.
Y2 Y3 Y4 Y
P
r
Y
LM1
IS1
SRAS1
AD1
Y1
Y1 Y2 Y3 Y4
P1
r1
IS/LM-AD/AS Model
ExpansionaryFiscal Policy
r2
P2
IS2
LM2
1 23
3
1 2
4
4
r3
If interest rates do not rise,Y increases from Y1 to Y4.
If the expansion causesinterest rates to rise from r1
to r2,, Y increases fromY1 to Y3.
As the expansion causesthe price level to rise fromP1 to P2,, Y increases from Y1 to Y2.
If workers anticipate the price level change, Y does not change, but the price level rises to P3.
AD2
5
5P3
LM3
SRAS2
0
0
r4
Y4 Y
P
r
Y
LM1
IS1
SRAS1
AD1
Y3
Y Y2 Y3 Y4
P1
r3
LM2
r0
P2
IS/LM-AD/AS Model
ExpansionaryMonetary Policy
LM3
Y1 Y2
1
1
4
4
3
32
2
AD2
5
5
SRAS2
If interest rates fall to r0,Y increases from Y1 to Y4.
If interest rates to fall to r1,Y increases from Y1 to Y3.
As the expansion causesthe price level to rise from,P1 to P2, Y increases from Y1 to Y2.
If workers anticipate theprice level changes, Ydoes not change, but theprice level rises to P3.
r1
0
0
P3
Cycles and the Real Wage
• Given an unchanging labor demand curve, employment rises when the real wage falls.
• This suggests that the real wage should be countercyclical; ie., it should fluctuate in the opposite direction from employment.
• However, data indicates that the real wage tends to be slightly procyclical; ie., it rises when output rises.
