Aggregate Supply
IB Economics
Continued…
—  Describe the term aggregate supply.
—  Explain, using a diagram, why the short-run aggregate supply curve
(SRAS curve) is upward sloping.
—  Explain, using a diagram, how the AS curve in the short run (SRAS) can
shift due to factors including changes in resource prices, changes in
business taxes and subsidies and supply shocks.
—  Explain, using a diagram,
that the monetarist/new classical model of the long- run aggregate
supply curve (LRAS) is vertical at the level of potential output (full
employment output) because aggregate supply in the long run is
independent of the price level.
—  Explain, using a diagram, that the Keynesian model of the aggregate
supply curve has three sections because of “wage/price” downward
inflexibility and different levels of spare capacity in the economy.
Continued…
—  Explain, using the two models above, how factors
leading to changes in the quantity and/or quality of
factors of production (including improvements in
efficiency, new technology, reductions in unemployment,
and institutional changes) can shift the aggregate
supply curve over the long term.
Equilibrium:
—  Explain, using a diagram, the determination of shortrun equilibrium, using the SRAS curve.
—  Examine, using diagrams, the impacts of changes in
short- run equilibrium.
Continued…
—  Explain, using a diagram, the determination of
long-run equilibrium, indicating that long-run
equilibrium occurs at the full employment level of
output.
—  Explain why, in the monetarist/new classical
approach, while there may be short-term
fluctuations in output, the economy will always
return to the full employment level of output in the
long run.
—  Examine, using diagrams, the impacts of changes
in the long-run equilibrium.
Continued…
—  Explain, using the Keynesian AD/AS diagram, that
—  the economy may be in equilibrium at any level of real output where AD intersects
AS.
—  Explain, using a diagram, that if the economy is in equilibrium at a level of
real output below the full employment level of output, then there is a deflationary
(recessionary) gap.
—  Discuss why, in contrast to the monetarist/new classical model, the economy can
remain stuck in a deflationary (recessionary) gap in the Keynesian model.
—  Explain, using a diagram, that if AD increases in the vertical section of the AS
curve, then there is an inflationary gap.
—  Discuss why, in contrast to the monetarist/new classical model, increases in
aggregate demand in the Keynesian AD/AS model need not
—  be inflationary, unless the economy is operating close to, or at, the level of full
employment.
Continued… HL Only
—  Explain, with reference to
the concepts of leakages (withdrawals) and injections, the
nature and importance of the Keynesian multiplier.
—  Calculate the multiplier using either of the following formulae.
—  1/(1- MPC)
—  1 /(MPS + MPT + MPM)
—  Use the multiplier to calculate the effect on GDP of a change
in an injection in investment, government spending or
exports.
—  Draw a Keynesian AD/AS diagram to show the impact of the
multiplier.
Links to Theory of
Knowledge
—  The Keynesian and Monetarist positions differ on
the shape of the AS curve.
—  What is needed to settle this question: empirical
evidence (if so, what should be measured?),
strength of theoretical argument, or factors
external to economics such as political conviction?
Introduction to Aggregate
Supply
AD- revisited
—  As we studied before, AD is the total output
produced in a nation. AD=C+I+G+(X-M)
—  This will affect households, firms and governments
budget
—  An increase in output will lead to an outward shift
in the AD curve and vise versa
Aggregate Supply:
—  Definition:
—  The total output produced by the firms in a nation
at a range of price levels in a given period of time.
Similarities to Microeconomics
—  Increase in price levels= increase in output
—  Decrease in price levels= decrease in output
—  (The law of supply)
The Aggregate Supply Curve
—  The aggregate supply curve is generally upward
sloping.
—  For our analysis, we will consider the short-run
aggregate supply curve and the long-run aggregate
supply curve.
LRAS
PL
SRAS
real GDP
Yfe
Short-run aggregate supply
(SRAS):
—  Illustrates the relationship between the price level
of a nation’s output and the level of output
produces
—  in the fixed-wage and price period, which is the
period of time following a change in aggregate
demand over which
Long-run aggregate supply
(LRAS):
—  Illustrates the relationship between the price level
and the level of output
—  in the flexible-wage and price period, which is the
period of time following a change in aggregate
demand over which all
Test Your Knowledge
—  In your groups, Answer the following questions
—  Post on edmodo
—  Refer to googleDocs for appropriate answer
—  Describe the term aggregate supply.
Video
—  Watch the Commanding Heights, part 1, up to 38th
min.
—  And complete the work sheet the provided
worksheet.
Competing Views of
Aggregate Supply
The neo-­‐classical View of Aggregate Supply: —  The ver'cal, LRAS curve reflects the theories of a school of economic thought known as the new (or neo)-­‐classical school of economics. —  read on the neo-­‐classical views-­‐ (next slide) —  In the new-­‐classical view, the aggregate supply curve is always VERTICAL LRAS
PL
real GDP
Yfe
Read
—  The Classical view of Aggregate Supply: During the boom era of the Industrial Revolu'ons in Europe, Britain and the United States, governments played a rela'vely small role in na'on’s economies. Economic growth was fueled by private investment and consump'on, which were leE largely unregulated and unchecked by government. When labor unions were weak and minimum wages and unemployment benefits were unheard of, wages fluctuated depending on market demand for labor. When spending in the economy was strong, wages were driven up and firms restricted their output in response to higher costs, keeping output near the full employment level. When spending in the economy was weak, firms lowered workers' wages without fear of repercussions from unions or government requiring minimum wages. Flexible wages meant labor markets were responsive to changing macroeconomic condi'ons, and economies tended to correct themselves in 'mes of excessively weak or strong aggregate demand. —  The Classical view of aggregate supply held that leE unregulated, a week or over-­‐
hea'ng economy would "self-­‐correct" and return to the full-­‐employment level of output due to the flexibility of wages and prices. When demand was weak, wages and prices would adjust downwards, allowing firms to maintain their output. When demand was strong, wages and prices would adjust upwards, and output would be maintained at the full-­‐employment level as firms cut back in response to higher costs. The Keynesian View of Aggregate Supply: —  The upwards sloping, SRAS curve reflects the theories of a school of economic thought known as the Keynesian school. —  Click here to read on the Keynesian view
—  In the Keynesian view, AS is horizontal below full-
employment and vertical beyond full employment!
PL
SRAS
real GDP
Yfe
Read
—  The Keynesian View of Aggregate Supply: John Maynard Keynes was an English economist who represented the Bri'sh at the Versailles treaty talks at the end of WWI. During the Great Depression, Keynes no'ced that, in contrast to what the neo-­‐
classical economists thought should happen, the world’s economies were not self-­‐
correcEng. —  Keynes believed that during a 'me of weak spending (AD), an economy would be unable to return to the full-­‐employment level of output on its own due to the downwardly inflexible nature of wages and prices. Since workers would be unwilling to accept lower nominal wages, and because of the role unions and the government played in protec'ng worker rights, the only thing firms could due when demand was weak was decrease output and lay off workers. As a result, a fall in aggregate demand below the full-­‐employment level results in high unemployment and a large fall in output. To avoid deep recession and rising unemployment aEer a fall in private spending (C, I, Xn), a government must fill the "recessionary gap" by increasing government spending. The economy will NOT "self-­‐correct" due to "s'cky wages and prices", meaning there should be an ac've role for government in maintaining full-­‐
employment output. AS Curves
PL
The Keynesian view
AS
real GDP
Yfe
The Classical view
PL
AS
Yfe
real GDP
—  In reality, neither view is totally correct.
•  Keynes was right in the short-run, because wages
and prices tend not to adjust quickly to changes in
the level of demand.
•  The new-classical are right in the long-run, because
over time, following a decrease or an increase in AD,
wages and prices tend to rise or fall accordingly.
•  causing output in the nation to return to a relatively
constant, full-employment level, regardless of the
level of AD.
Discussion:
—  Discuss with your partner and answer the following
question:
—  Why does the SRAS curve slopes upward? Why does
the LRAS curve is vertical?
—  Post your answer on Edmodo
Test Your Knowledge
—  In your groups, answer the following questions
—  Post your answers on edmodo
—  Refer to googleDocs for appropriate answers
—  Explain, using a diagram, that the monetarist/new
classical model of the long- run aggregate supply curve
(LRAS) is vertical at the level of potential output (full
employment output) because aggregate supply in the
long run is independent of the price level.
—  Explain, using a diagram, that the Keynesian model of
the aggregate supply curve has three sections because
of “wage/price” downward inflexibility and different
levels of spare capacity in the economy.
Short-run Aggregate
Supply
—  The Keynesian theory of rela'vely inflexible wages and prices is reflected in the short-­‐run aggregate supply curve —  which is rela'vely flat below full employment (Yfe) and rela'vely steep beyond full employment. Explanation for the shape of
SRAS
—  Slopes upwards because at higher prices, firms
respond by producing a greater quantity of output
—  As price level falls, firms respond by reducing
output
—  At low levels of output (when unemployment is
high), firms are able to attract new workers without
paying higher wages, so prices rise gradually as
output increases
—  At high levels of output, when resources in the
economy are fully employed, firms find it costly to
increase output as they must pay higher wages and
other costs.
—  Increases in output are accompanied by greater
and greater levels of inflation as an economy
approaches and passes full employment
—  See the graph in the next slide
SRAS
PL
P4
Pfe
P3
P2
P1
Y1
Y2
real GDP
Y3
Yfe
Y4
Long-run Aggregate Supply
—  The new-­‐classical view of AS is reflected in the ver'cal, long-­‐
run AS curve, which shows that output will always occur at the full employment level (Yfe). Explanation for the shape of
LRAS
—  AS is vertical at the full-employment level of output
(Yfe),
—  implying that whatever the level of AD, the economy
will always produce at full employment.
—  When AD is very low, wages and prices fall so that
firms can continue to employ the same number of
workers and produce the same output.
—  Output will not decrease when AD decreases
—  When AD is very high, firms will see wages rising
and therefore they will NOT hire more workers,
—  and will just pass their higher costs onto buyers as
higher prices.
—  Output will not increase when AD increases
—  Wages and prices must be completely flexible in the
long-run for Yfe to always prevail
LRAS
PL
SRAS
P4
Pfe
P3
P2
P1
Y1
Y2
real GDP
Y3
Yfe
Y4
Discussion
—  With your partner, distinguish between the SRAS
and LRAS
The Determinants of
Aggregate Supply
—  A change in AD is not the only factor that can lead to a change in an economy’s short-­‐run equilibrium level of output. —  AS can also shiE, if one of the determinants of aggregate supply changes. IMPORTANT (test question)
The Determinants of Aggregate Supply: —  When any of the following change, aggregate supply will either decrease and shiE inwards (or up, graphically) or decrease and shiE outwards (or down, graphically). —  Wage rates: The cost of labor. Higher wages cause SRAS to decrease, lower wages cause SRAS to increase •  Resource costs: Rents for land, interest on capital; as these rise and fall, so does AS •  Energy and transportaBon costs: Higher oil or energy prices will cause SRAS to decrease. If costs fall, SRAS increases —  Government regulaBon: Regula'ons impose costs on firms that can cause SRAS to decrease •  Business taxes: Taxes are a monetary cost imposed on firms by the government, and higher taxes will cause SRAS to decrease •  Exchange rates: If a country’s producers use lots of imported raw materials, then a weaker currency will cause these to become more expensive, reducing SRAS. •  A stronger currency can make raw materials cheaper and increase AS.
Short-run Equilibrium in the AD/AS
Model – Full Employment
—  By considering both the aggregate supply AND the aggregate demand in a na'on, —  we can analyze the levels of output, employment and prices in an economy at any par'cular period of 'me
LRAS
PL
SRAS
Pfe
AD1
real GDP
Yfe
Consider the economy shown here:
When equilibrium occurs at full-employment:
•  The total demand for the nation’s output is just high
enough for the economy to produce at its full
employment level in the short-run.
•  Nearly everyone who wants a job has a job and the
nation’s capital and land are being fully utilized.
Unemployment is at its Natural Rate (the NRU)
•  (frictional + structural unemployment) / labor force
•  Since the economy is at full-employment, we can
assume that the macroeconomic objectives are
being met:
Ø  Price level stability,
Ø  Full employment
Ø  Economic growth.
LRAS SRAS
PL
Pfe
AD1
See graph
real GDP
Yfe
What happens if the AD
falls?
Short-run Equilibrium in the AD/AS
Model – AD decreases
—  On the previous slide we say an economy that was producing at its full employment level, e.g. a strong, healthy economy. —  But what if something changed, and AD fell due to a fall in consumpEon, net exports, investment or government spending?
Explaining the graph (test)
At AD2:
•  A fall in expenditures has
caused AD to decrease to AD2
LRAS SRAS
PL
•  In the short-run, firms will fire
workers and reduce output to
Y2. Price level fall, but only
slightly, to P2
•  The economy is no longer at full
employment, and is in a
demand-deficient recession at Y2.
Ø  Price level has fallen slightly
Ø  Employment has decreased
Ø  National output has decreased,
there is a recessionary gap equal
to the difference between actual
output and full-employment output
Pfe
P2
AD1
AD2
Y2
Yfe
Recessionary Gap
real GDP
What happens when the AD
decreases in the LR
equilibrium?
Long-run Equilibrium in the AD/AS
Model: AD decreases
—  When AD decreases, output will decrease in the short-­‐run because firms will have to lay workers off to cut costs and lower their prices. —  However, in the long-­‐run, wages and prices are flexible, so output will return to its full employment level.
At AD2 in the long-run:
•  Over time, unemployed workers will begin PL
accepting lower wages, which will reduce
production costs for firms
•  At lower wage rates, SRAS increases to
SRAS1, firms begin hiring back the
workers they fired when AD first fell
•  Output will return to Yfe, and prices will
P2
fall to Pfe1. The economy “self-corrects” in
the long-run
P
Ø  Output returns to full employment
1
Ø  Wages are lower, but prices are too
Ø  The economy recovers on its own from the
recession in the long-run
LRAS SRAS
SRAS1
AD1
fe
AD2
Y2
real GDP
Yfe
What happens when the AD
increases in the SR
equilibrium?
Short-run Equilibrium in the AD/AS
Model – AD increases
—  Assume that either consumpEon, investment, net exports or government spending increased, causing the AD curve to shiE from AD1 to AD3
LRAS SRAS
PL
P3
AD3
Pfe
AD1
real GDP
Yfe Y3
Inflationary Gap
The Graph
At AD3:
•  An increase in demand led to firms
wanting to produce more output, which
increases to Y3.
•  Wages are relatively inflexible in the shortrun, so firms can hire more workers, and
the economy produces beyond its full
employment level.
•  The economy experiences demand-pull
inflation
Ø  Price level has risen due to greater demand
for the nation’s output
Ø  Employment has increased
Ø  The economy is beginning to ‘overheat’,
and there is an inflationary gap equal to the
difference between actual output and fullemployment output
LRAS SRAS
PL
P3
AD3
Pfe
AD1
real GDP
Yfe Y3
Inflationary Gap
What happens when the AD
increases in the LR
equilibrium?
Long-run Equilibrium in the AD/AS
Model – AD increases
—  In the long-­‐run, wages and prices will adjust to the level of aggregate demand in the economy. —  When AD grows beyond the full employment level, this means wages will rise in the long-­‐run —  leading producers to reduce employment and output back to the full-­‐employment level
The Graph
At AD3 in the long-run:
PL
•  Demand for resources has driven up
their costs (wages, rents, interest have Pfe
3
all risen)
P3
•  Facing rising costs of production, firms
begin reducing employment and output,
and passing higher costs onto
consumers as higher prices.
•  Output returns to Yfe, and price level
rises to Pfe3
Ø  The economy has self-corrected from the
rising AD
Ø  Output is back at its full-employment
level
Ø  There is more inflation in the economy
(higher price levels)
LRAS
SRAS1
SRAS
AD3
AD1
real GDP
Yfe
More stuff on AS
Almost done, I promise
Negative Supply Shocks
-Stagflation—  Assume that a determinant of AS changes which causes the short-­‐run aggregate supply curve to decrease, and shiE to the leE. —  What results is a situa'on known as stagfla&on
—  DEFENIITON: Stagflation, An increase in the
average price level combined with a decrease in
output, caused by a negative supply shock.
—  “Stagnant growth” and “inflation” together make
“stagflation”
The Graph
•  Assume higher energy costs caused
SRAS to decrease to SRAS2.
•  To off-set higher energy costs, firms
must lay off workers, reducing
employment.
•  Higher costs must be passed onto
consumer as higher prices, causing
inflation.
•  An economy facing stagflation will only
self-correct if resources costs fall in the
long-run, which may occur if wages fall
due to a large increase in
unemployment.
LRAS
SRAS2
PL
SRAS1
P2
Pfe
AD
Y2
real GDP
Yfe
Positive Supply Shock
-Economic Growth—  While a nega've supply shock can be disastrous for an economy, a posi've supply shock has very beneficial effects on employment, output and the price level. —  Assume ,for example, a na'on signs a free trade agreement and now lots of new resources can be imported at very low costs.
The Graph
LRAS
PL
SRAS increases to SRAS3:
•  Cheaper resource costs allow firms to
produce more output with the same
amount of workers and capital.
•  Lower costs are passed onto consumers
as lower prices, Pfe falls to P3
P
•  Output increases to Y3, indicating short- fe
P3
run economic growth has occurred.
•  If the lower costs remain permanent,
then eventually LRAS will increase and
Y3 will become the new full-employment
level of output, indicating long-run
economic growth
SRAS1
SRAS3
AD
real GDP
Yfe
Y3
Long-run Economic Growth in
the AD/AS Model
—  So far we have illustrated demand-­‐deficient recessions, demand-­‐pull inflaEon, negaEve and posiEve supply shocks. —  But real, long-­‐run economic growth requires that not only AS or AD increase, rather that both AS AND AD increase. The Graph
LRAS1
PL
Long-run Economic Growth:
•  For national output to grow in the
long-run, AD, SRAS and LRAS must
all shift outward.
•  This can be cause by an
improvement in the production
Pfe
possibilities of the nation, combined
with growing demand for the nation’s
output.
•  The quality and/or quantity of
resources must increase:
Ø
Ø
Ø
Ø
Better technology,
Larger population,
Better educated workforce,
More natural resources, and so on.
LRAS2
SRAS1
AD1
Yfe1
real GDP
Yfe2
SRAS2
AD2
Video
—  Watch the Video and answer the following
questions on edmodo
—  Refer to googleDocs for appropreate answer
—  http://www.econclassroom.com/?p=2807
Test Your Knowledge
—  Explain, using a diagram, the determination of short-run equilibrium,
using the SRAS curve.
—  Examine, using diagrams, the impacts of changes in short- run
equilibrium.
—  Explain, using a diagram, the determination of long-run equilibrium,
indicating that long-run equilibrium occurs at the full employment level
of output.
—  Explain why, in the monetarist/new classical approach, while there may
be short-term fluctuations
in output, the economy will always return to the full employment level of
output in the long run.
—  Examine, using diagrams, the impacts of changes in the long-run
equilibrium.
HWK.. Test Prep
—  Practice questions:
—  IB Econ, Jason Welker
—  Page 284