Aggregate Supply
•How the Aggregate supply curve illustrates the
relationship between the aggregate price level
and the quantity of aggregate output supplied in
the economy.
•What factors can shift the aggregate supply
curve.
•Why the aggregate supply curve is different in
the short run than in the long run.
Aggregate Supply
• Economists model economy-wide consumption
of goods and services with something called
Aggregate Demand.
• In the previous chapter, we saw that the AD
curve is downward sloping
• This shows that consumption of goods and
services (real GDP) declines when the
aggregate price level rises.
Aggregate Supply
• The line parallel to AD is Aggregate Supply
• Aggregate Supply shows us the relationship
between economy-wide production and the
Aggregate Price Level.
• In the short run, there is a positive slope to
the SRAS curve.
• In the long run, the LRAS curve is vertical at
the level of potential GDP.
The Short-Run Aggregate Supply Curve
• Economists believe that in the short run, there
is a positive relationship between the
aggregate price level and quantity of
aggregate output supplied, other things equal.
• In other words, the SRAS curve is upward
sloping like supply curves studied in
microeconomics
• Why??
The Short-Run Aggregate Supply Curve
• What is the goal of the producers?
– To earn a profit.
• So each producer must ask the same basic
question: is producing a unit of output profitable
or not?
• Profit per unit: Profit per unit of output =
Price per unit of output – Production cost per unit of output.
The Short-Run Aggregate Supply Curve
• Suppose that the price of a unit of output
increased, but production cost of that unit stayed
the same.
• Profit on that unit will rise, and so it will be
produced.
• What if the price of output increased 5%, while
the production cost increased 1%?
• Profit on that unit will also rise, so it will be
produced.
The Short-Run Aggregate Supply Curve
• Summary:
• If the price of a unit of output is rising faster
than the cost of producing that unit of output,
that unit of output will be produced.
• This is exactly what economists believe
happens in the short run.
• This gives us an upward sloping curve
The Short-Run Aggregate Supply Curve
• What explains this?
• Some input prices are “sticky” – This just
means that they don’t rise or fall very quickly
in response to a change in demand for them.
• Example: Labor
• Wages are determined in the labor markets.
Let’s consider what happens in both good and
bad economic times
The Short-Run Aggregate Supply Curve
• Scenario 1 (A strong economy)
• Demand for products is strong and producers are selling
their output like hotcakes, with rising output prices, and
profit per unit of output is skyrocketing!
• Eventually they need to hire more workers, and so the
demand curve for labor shifts outward.
• Yet employers are reluctant to immediately raise
nominal wages and some employees have already
agreed to be paid a lower wage so those wages are fixed
for the time being.
• Eventually the competition for good workers gets so
fierce that nominal wages begin to rise.
The Short-Run Aggregate Supply Curve
• Scenario 1 (A weak economy)
• Demand for products is weak, the economy is in recession.
• Producers are selling fewer units of output, with falling output
prices, and profit per unit of output is crashing!
• Eventually they need to reduce employment of workers, and so
the demand curve for labor shifts inward.
• Employers are somewhat reluctant to immediately lower
nominal wages because they will lose employees.
• Some employees have already signed contracts at a higher
wage so those wages are fixed for the time being.
• Eventually the labor market gets so weak, and unemployment
is so high, that nominal wages begin to fall.
• Bottom line, the price of output fell quickly with weaker
demand, but the price of labor (nominal wage) fell much more
slowly.
Shifts of the Short-Run AS Curve
• The SRAS curve is upward sloping, but it can also
shift to the right of left.
• An increase, or outward shift, in SRAS means that
producers are willing to produce more aggregate
output at any price level.
• A decrease in SRAS means that the SRAS curve
shifts to the left.
• A leftward shift implies that the quantity of
Aggregate Output falls at any aggregate price
level
Short Run AS Shifts
• Changes in Commodity Prices
• Changes in Nominal Wages
• Change in Productivity
Change in Commodity Prices
• A commodity is a standardized input bought and
sold in bulk quantities.
• Examples: oil, copper, steel
• These commodities are production inputs for
many final products so higher commodity prices
make it more costly for firms economy-wide to
produce.
• This would shift SRAS to the left.
• An economy-wide decrease in commodity prices
would shift the SRAS curve to the right
Changes in Nominal Wages
• A very important input to production is labor
and the current price of labor is the nominal
wage.
• Gradually these nominal wages change due to
changes in the labor markets.
• In the Nominal Wage were to increase, the
SRAS will shift to the left
Change in Productivity
• Suppose workers at a factory are provided
with better tools so that they can increase
output with the same amount of effort.
• If this is happening across the economy, the
same amount of labor can produce more
goods and services and SRAS shifts to the right
The Long-Run Aggregate Supply Curve
• LRAS
• The reason the SRAS was upward sloping was
because nominal wages were sticky
– (which means when the Aggregate Price Level
rises, nominal wages rise more slowly)
• So, what if they were not?
• OR, what if there was enough time for all
wages to adjust?
LRAS
• If the price of output increased by 5% and nominal
wages had enough time to increase by 5%, there
would be no profit incentive to increase output.
• All we would experience would be an increase in
the Aggregate Price Level.
• The LRAS is vertical
• The LRAS touches the horizontal axis at the
economy’s potential output, Yp: The level of real
GDP the economy would produce if all prices,
including nominal wages, were fully flexible.
LRAS
• Many economists believe that, given enough
time, the economy will adjust back to this
level of output.
• NOTE: The LRAS gradually shifts to the right
over time.
– Our economy’s potential output has increased due
to better technology, and a larger and more
educated workforce.
From the Short Run to the Long Run
• The economy from year to year fluctuates around the
level of potential output Yp.
• Some years the economy is weak and real GDP lies
below Yp.
• Other years the economy is extremely strong and real
GDP lies above Yp.
• In the AD/AS model, the economy is always operating
along the SRAS supply curve
• But only sometimes does this coincide with the
intersection of SRAS and LRAS.
• This model predicts however, that, in the long run, the
economy will adjust to where SRAS intersects LRAS at Yp
• HOW?
Scenario 1 – The economy is weak and in a recession. In
this scenario, current real GDP Y1 < Yp
So what is expected to happen? A weak labor market has falling demand for labor.
There are many unemployed workers. Employers find that they can get workers to
accept lower wages. Eventually nominal wages fall and SRAS shifts to the right until
current output is equal to Yp.
Scenario 2 – The economy is booming. In this scenario,
current real GDP Y2 > Yp
So what is expected to happen? A strong labor market has rising demand for labor.
There are very few workers that are unemployed. Employers are scrambling to find
scarce employees. Eventually nominal wages rise and SRAS shifts to the left until
current output is equal to Yp.
Class Activity – Determine the effect on short-run AS of each of the
following events. Explain whether it represents a movement along
the SRAS curve (up of down) or a shift of the curve (left or right).
• Respond to the following activities:
1. Hackers from a foreign country disable most corporate
computing systems. This disruption continues off and on for
several months
2. The price of grain, a key commodity, drastically increases as
the nation switches to more biofuels as sources of energy
3. The First Lady’s goal of doubling the fraction of high school
seniors that graduate from college is successful.
4. Due to a weak economy, the consumer price index falls for
several consecutive months.
5.Labor unions are successful in organizing members
throughout the economy and they negotiate higher wages
and benefits.