Aggregate Supply

Chapter Six:
Aggregate Supply
6.1 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.
Modeling Production and Real
• The aggregate production function shows the
relationship between inputs (labour) to
production and the quantity of aggregate total
output (GDP) supplied
Real GDP
Production Function
Number of People Working
A Range for Potential Output
and the LAS Curve
• The position of the long-run aggregate
supply curve is determined by potential
output. Eg. On the PPF
• Potential output – the amount of goods
and services an economy can produce
when both labor and capital are fully
employed. Only one level of production
possible! Eg one machine, one pencil
A Range for Potential Output
and the LRAS Curve
• Potential output – Only one level of
production possible! Eg one machine, one
pencil, one minute, sell for $1
• Add worker will slow down production –
Diminishing Marginal Returns: additional
output from worker less than previous in
– In LR, lay off worker and reach equilibrium
input/output in production and prices
A Range for Potential Output
and the LAS Curve
– In LR, lay off worker and reach equilibrium
input/output in production and prices
– LR assumes full information!
– If sell pencil for more money then supplier of
wood charge more and workers demand more
wages more immediately bring back in
equilibrium with no change of output
– In the SR no full info., employee and supplier
get paid same and owner makes profit so
production expands LR supply curve tilts over
A Range for Potential Output
and the LAS Curve
– LR assumes full information!
Supplier Sell $0.5 > Worker pay $0.5 > Owner Sell $2 = $1 profit
Owner Sell $3 for $2 profit but then > Supplier Sell $1 > Worker pay $1
Profit back down to $1 no incentive to produce more
– SR
Supplier sell $0.5 > Worker pay $0.5 > Owner Sell $2 = $1 profit
Owner Sell $3 for $2 profit but supplier and worker don’t know so profit
stays at $2 and there is an incentive to produce more
The Labour Market
6.2 Shifts in the LRAS Curve
• The LAS curve shows the longrun relationship between output
and the price level.
• The position of the LAS curve
Price Level
depends on potential output –
the amount of goods and
services an economy can
produce when both capital and
labor are fully employed.
• Economic
growth eg. New
tech, more human and physical
capital, more resources shifts
the LRAS to the right.
Shifts in the LRAS Curve
• Economic
growth eg. New tech, more human and physical capital,
more resources shifts the LRAS to the right.
• Productivity Increases
• Demand for the more productive labour increases and wages follow
Labour Market
Real Wage
Number Employed
6.3 Aggregate Demand
• The LRAS curve describes the Real GDP
• The aggregate demand curve shows the
relationship between the aggregate price
level and the quantity of aggregate
domestic output demanded by
households, businesses, and the
The Aggregate Demand Curve
• The aggregate demand (AD) curve
shows how a change in the price level
changes aggregate expenditures on all
goods and services in an economy.
• It shows the level of expenditures that
would take place at every price level in the
economy. ie. willingness to spend
The Aggregate Demand Curve
Downward Sloping
• It is downward-sloping for two reasons:
– The first is the Real Balance Effect of a change in
the aggregate price level—a higher aggregate price
level reduces the purchasing power of households’
wealth and reduces consumer spending.
– The second is the interest rate effect of a change in
aggregate the price level—a higher aggregate price
level reduces the purchasing power of households’
money holdings, the BofC rises interest rates to cool
the economy (also have less commercial deposits too
banks raise r to attract more deposits) leading to a fall
in investment spending and consumer spending
The Real Balance Effect
• Real Balance Effect– a fall in the price
level will make the holders of money and
other financial assets richer, so they buy
• Most economists accept the logic of the
wealth effect, however, they do not see
the effect as strong.
The Interest Rate Effect
• The interest rate effect works as follows:
a decrease in the price level 
increase of real cash 
banks have more money to lend 
interest rates fall 
investment expenditures increase
The Open Economy Effect
• Works as follows:
• NX = X-M
Decrease in the CDN price level 
CDN goods less expensive 
Foreigners buy more CDN goods 
Foreigners buy less of own goods 
Canadians buy more CDN goods (X>M) = NX? 
Increase in real goods purchased (expenditures) in
The Slope of the AD Curve
• The AD is a downward sloping curve.
• Aggregate demand is composed of the
sum of aggregate expenditures.
Expenditures = C + I + G +(X - M)
The Aggregate Demand Curve
• Aggregate Demand is the total value of real GDP that
all sectors of the economy (C + I + G + Xn) are willing
to purchase at various price levels.
When the
price level
less output.
AD Shift Factors
• The aggregate demand curve shifts because of
Changes in expectations eg gas prices
Changes in wealth eg lottery, r through I)
Changes in the stock of physical capital
NOT through price changes
• Policy makers can use fiscal policy and
monetary policy to shift the aggregate demand
Not in this chapter but will be in future chapters
Shifts of the Aggregate Demand
Curve – Rightward Shift
Shifts of the Aggregate Demand
Curve – Leftward Shift
AD and the Multiplier
1. Initial effect = $100 increase in X (exports) => $100 increase in AD (shift)
2. Workers who make goods get $100 increase in income => SPEND!!
3. Bar owners get $100 increase in income
Multiplier effect = 200
The change in total expenditures = 300 ($100+($100+$100))
AD and the Multiplier
Initial effect = 100 increase in exports
effect = 200
Change in total
expenditures = 300
Real output
6.4 LR Equilibrium, the price
Level and Economic Growth
• The AS/AD model is fundamentally
different from the microeconomic
supply/demand model.
The AS/AD Model
• Microeconomic supply/demand curves
concern the price and quantity of a single
The AS/AD Model
• In the AS/AD model the price of everything
is on the vertical axis and aggregate
output is on the horizontal axis.
• So there is no substitution
• Equilibrium occurs when AD=AS ie.
Planned Expenditures = Planned Production
Long-Run Macroeconomic
LR equilibrium of
$6 trillion in real GDP
and price level of 100.
AD>AS => Sales??
Supply Creates Its Own Demand!
• Deflation is a decline in the general
level of prices for a period of years
– This last occurred between 1929 -33
Growth and Deflation
• Secular Deflation: persistent decline in prices from economic growth
• Avoided price decrease by increasing aggregate demand
•What if AD shifts out faster than LRAS?
Real GDP/ Year
Price Level
Price Level
Real GDP/ Year
6.5 Causes of Inflation
• Defining inflation
– This is the OPPOSITE of deflation
– Generally, we consider inflation to be
a sustained rise in the average price
level over a period of years
• When the overall price level is rising,
the prices of some goods and services
are going down [e.g., TV prices in the
1970s and the 1980s, the price of VCRs,
and more recently the price of cellular
Theories of the Causes of
• Demand-Side Inflation
• Cost-Push (Supply Side) inflation
Demand-Side Inflation
• When there is excessive demand for
goods and services, we have demandpull inflation
– This occurs when people are willing and
able to buy more output than our economy
can produce because our economy is
already operating at full capacity
Demand-Side Inflation
• Demand-pull inflation is often summed
up as “too many dollars chasing too
few goods”
– Just where did all of this money come
Cost-Push Inflation
• There are three variants of costpush inflation
– The wage-price spiral
– Profit-push inflation
– Supply-side cost shocks
Cost-Push Inflation: The WagePrice Spiral
Wages constitute nearly two-thirds of
the cost of doing business
– Whenever workers receive a significant
wage increase, this increase is passed
along to consumers in the form of
higher prices
– Higher prices raise everyone’s cost of
living, engendering further wage
Cost-Push Inflation: Profit Push
– Because just a handful of firms
dominate many industries, they
have the power to administer
prices rather than accept the
dictates of the market forces of
supply and demand
– To the degree that they are able,
these firms will respond to any rise
in cost by passing them on to their
Cost-Push Inflation: SupplySide Cost Shocks
– Finally, we have supply-side shocks,
most prominently the oil price shocks
of 1973-74 and 1979
• OPEC nations raised the price of oil
• When the price of oil rises, the cost of making
many other things rise as well
– Cost increases are quickly translated
into price increases
Anticipated and Unanticipated
Inflation: Who Is Hurt?
• Debtors (people who take on
debt) benefit from unanticipated
– They get to repay their loan in dollars
that are worth less than the dollars they
– The biggest debtor and gainer from
unanticipated inflation has been the U.S.
Anticipated and Unanticipated
Inflation: Who Is Hurt by
Inflation and Who Is Helped?
• Creditors, the people who lend
out money, are hurt by
unanticipated inflation
– The ultimate creditors, or lenders,
are the people who put their money
in banks, life insurance, or any
other financial instrument paying a
fixed rate of interest
Who is hurt by Unanticipated
• People who live on fixed incomes,
particular retired people who
depend on pensions
Anticipated and Unanticipated
• When inflation is fully anticipated
there are no winners and losers
– Creditors have learned to charge
enough interest to take into account,
or anticipate, the rate of inflation
over the course of the loan
• This is tacked onto the regular interest
rate that the lender would charge had
no inflation been expected