ECONOMICS
What does it mean to me?
Part VIII:
•Aggregate Supply
•Demand-Pull Inflation
•Cost-Push Inflation
READ Krugman Sec 4, Mod 18, 19
Mankiw Ch 33, 30
DO Morton Unit 3
Module 18
Aggregate Supply:
Introduction and
Determinants
•KRUGMAN'S
•MACROECONOMICS for AP*
Margaret Ray and David Anderson
READ
Krugman Section 4, Module 18
Mankiw Ch
Morton Unit 3
What you will learn
in this Module:
• 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 from in the long
run
Krugman, Sec 4, Mod 18
AGGREGATE SUPPLY
A schedule or a curve showing the level of real
domestic output which will be produced at each
price level.
Higher price levels create an incentive for
enterprises to produce and sell more output,
while lower price levels reduce output.
One can divide the supply curve into two parts:
the short-term supply curve and the long-term
supply curve.
The short-run relationship refers to a
period when output can change in
response to supply and demand, but
input prices have not yet been able to
adjust. Higher prices give incentive for
enterprises to produce and sell more
output, while lower prices reduce
output.
P
R
I
C
E
LRAS
P
R
I
C PL1
E
L
E PL0
V
E
L
S
SRAS
B
A
RGDP0
RGDP1
Real Gross Domestic Product
The long-run supply curve reflect the
relationship between RGDP produced
and price level, once input prices have
been able to respond to changes in
output prices. The vertical curve
reflects the fact that producers are
willing to supply is not affected by
changes in price.
L
E
V
E
L
S
RGDPFE
Real Gross Domestic Product
The Short-Run Aggregate Supply Curve
*Krugman
Aggregate Supply
• The relationship
between the
price level and
the real GDP
supplied
Krugman, Sec 4, Mod 18
The Short-Run Aggregate Supply
Curve
• Profit per unit of output
• Nominal Wage
• Sticky Wages
• SRAS
Krugman, Sec 4, Mod 18
Shifts of the Short-Run Aggregate
Supply Curve
• ∆ Commodity Prices
• ∆ Nominal Wages
• ∆ Productivity
Krugman, Sec 4, Mod 18
The Long-Run Aggregate Supply Curve
• Flexible Wages
• Long Run
• LRAS
• Potential Output
• Factors that shift LRAS
Krugman, Sec 4, Mod 18
From the Short Run to the Long Run
Krugman, Sec 4, Mod 18
What causes the aggregate supply curves to shift?
1. Changes in input prices
a) Domestic resource availability
a1 Land
a2 Labor
a3 Capital
DETERMINANTS
a4 Entrepreneurial ability
b) Prices of imported resources
c) Market power
2. Change in Productivity
3. Change in legal-institutional environment
a) Business taxes and subsidies
b) Government regulations
Of
AGGREGATE
SUPPLY
1. Changes in input prices
Input prices or resource prices
are a major determinant of
aggregate supply.
Ceteris paribus, higher input
prices increase per-unit
production costs and reduce
aggregate supply.
Lower input prices do just the
opposite.
a) Domestic resource availability
a1 Land
Land resources might expand through discoveries of mineral
deposits, irrigation of land, or technical innovations.
An increase in the supply of land resources lowers the price of
land inputs, lowering per-unit costs.
Two examples of reductions in land-resource availability may
also be cited:
1) the widespread depletion of the nation’s underground water
reserves through irrigation,
2) the nation’s loss of topsoil through intensive farming.
Eventually, these problems may increase water and land prices
and shift the aggregate supply curve leftward.
a) Domestic resource availability
a2 Labor
About 75 percent of all business costs are wages or
salaries. An increase in the availability of labor
resource reduces the price of labor and increases
aggregate supply.
(i.e.) Aftr World War
II, the influx of women
into the labor force
placed a downward
pressure on wages
and expanded U.S.
aggregate supply.
(i.e.) Immigration of
employable workers
from abroad has
historically increased
the availability of
labor in the U.S. and
reduced wages.
a) Domestic resource availability
a3 Capital
Aggregate supply usually increases when society adds to its stock
of capital. Such an addition would happen if society saved more of
its income and used the savings to purchase capital goods.
On the other hand, aggregate supply
declines when the quantity and quality of
the nation’s stock of capital diminishes.
For example, during the Great
Depression of the 1930s, the U.S. capital
stock deteriorated because new
purchases were insufficient to offset the
normal wearing out and obsolescence of
plant and equipment. Aggregate supply
declined.
a) Domestic resource availability
a4 Entrepreneurial ability & Technology
Ceteris paribus, the amount of entrepreneurial ability available to the
economy may change, shifting the aggregate supply curve.
If entrepreneurial
activities or
technology lowers the
costs of production
and expands what
might be produced in
the economy, then the
aggregate supply
curves both shift to
the right.
b) Prices of imported resources
A decrease in the prices of imported resources expands a
nation’s aggregate supply; an increase in the prices reduces
aggregate supply.
Exchange rate fluctuations are one factor that alters the price
of imported resources. If the dollar price of a foreign
currency falls--the dollar appreciates--this enables U.S. firms
to obtain more foreign currency with their dollar. Under these
conditions, U.S. firms would expand their imports of foreign
resources and realize reductions in per-unit production costs
at each level of output. Falling per-unit production costs of
this type shift the U.S. aggregate supply curve to the right.
An increase in the dollar price of foreign currency--dollar
depreciation-- raises the prices of imported resources.
c) Market power
Market power is the ability to set a price above the price that would occur in a
competitive situation.
The rise and fall of market power held cut the Organization of Petroleum
Exporting Countries (OPEC) during the past three decades is a good
illustration. The tenfold increase in the price of oil that OPEC achieved during
the 1970s permeated the economy, drove up per-unit production costs, and
jolted the U.S. aggregate supply curve.
2. Change in Productivity
Productivity relates a nation’s level of real output to the quantity
of input used to produce that output. In other words,
PRODUCTIVITY is a measure of average real output, or of real
output per unit of input:
Productivity =
total output
total input
An increase in productivity means the economy can obtain more
real out put from its limited resources--its inputs.
How does an increase in productivity affect the
aggregate supply curve?
We first need to see how a change in productivity alters the
per-unit production cost.
Suppose real output is 10 units, 5 units of input are needed to
produce that quantity, and the price of each input unit is $2.
Then
Productivity =
total output
total input
=
10
5
= 2
and
Per-unit
Production =
cost
Total input costs$2 x 5
=
Total output
10
= $1
3. Change in legal-institutional environment
a) Business taxes and subsidies
Higher business taxes, such as sales, excise, and payroll
taxes, increase per-unit costs and reduce aggregate supply in
much the same way as a wage increase.
Similarly, a business subsidy--as payment or tax break by
government to firms--reduces production costs and increases
aggregate supply.
3. Change in legal-institutional environment
b) Government regulations
It is usually costly for businesses to
comply with government regulations.
Therefore, regulation increases perunit production costs and shifts the
aggregate supply curve leftward.
“Supply-side” proponents of
deregulation of the economy have
argued forcefully that, by increasing
efficiency and reducing the paperwork
associated with complex regulations,
deregulation will reduce per-unit costs,
and shift the aggregate supply curve
rightward.
Some determinants of aggregate supply affect only the shortterm AS curve and not the long-term AS.
For example, if wages increase without increasing production,
the cost of production will cause the SRAS to shift but not the
LRAS. However, the addition/loss of workers to the labor
force, ceteris paribus, WILL cause LRAS to shift.
Supply & demand in factor
markets (capital, labor, land)
will cause prices to change
and thusly, affect only
SRAS……UNLESS this is a
reflection of a permanent
change of those inputs. If it
is permanent, it will affect
LRAS.
LRAS
P
R
I
C
E
SRAS1
SRAS0
PL1
L
E PL0
V
E
L
RGDPF
E
Real Gross
Domestic Product
Another influence
that can cause the
increase in the cost
of production are
natural disasters.
Hurricanes,
tornados, flooding,
earthquakes and
droughts could
cause the short-run
AS to shift to the
left, ceretis paribus.
These shifts are
called SHOCKS.
Module 19
Equilibrium in
the Aggregate DemandAggregate Supply Model
•KRUGMAN'S
•MACROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The difference between short-run and
long-run macroeconomic equilibrium
• The causes and effects of demand
shocks and supply shocks
• How to determine if an economy is
experiencing a recessionary gap or an
inflationary gap and how to calculate the
size of the output gaps
Krugman, Sec 4, Mod 19
The AD-AS Model
• Model used to analyze
economic fluctuations
Krugman, Sec 4, Mod 19
Short-Run Macroeconomic
Equilibrium
• Short-Run Macroeconomic
Equilibrium
• Price Level
• Aggregate Output
• Shortage/Surplus
• Relative Declines
Krugman, Sec 4, Mod 19
Shifts of Aggregate Demand: ShortRun Effects
• Demand Shock (event
that shifts the AD curve,
such as change in wealth or
expectations, Fiscal or
Monetary Policy, or the size
of existing capital stock of
physical capital)
• Negative Demand
Shock (Great Depression)
• Positive Demand
Shock (increase in gov
Krugman, Sec 4, Mod 19
purchases in WWII)
Shifts of the SRAS Curve
Supply Shock (an event that
shifts the short-run AS)
Negative Supply Shock
(raises production cost &
reduces the Q of producers
who supply at any cost) (ex:
oil supply 1973-1979)
• Stagflation (a
combination of inflation
& stagnating (falling)
aggregate output)
Positive Supply Shock
Krugman, Sec 4, Mod 19
(reduces prod costs &
increases Q supplied at any
PL) (ex: internet bubble
1995-2000)
Shifts of the Short-Run Aggregate
Supply Curve
*Krugman
Shifts of the Short-Run Aggregate Supply
Curve
Changes in
Commodity prices
Nominal wages
Productivity
*Krugman
EQUILIBRIUM: REAL OUTPUT AND THE
PRICE LEVEL
The intersection of the Aggregate
Demand Curve and the ShortRun Aggregate Supply Curve
determines the equilibrium level
of real output and price level.
When equilibrium occurs at the
potential output level (on the
LRAS), the economy is operating
at full-employment.
LRAS
P
R
I
C
E
SRAS
L PL0
E
V
E
L
AD
RGDPF
E
Real Gross
Domestic Product
Long-Run Aggregate Supply Curve
*Krugman
Actual and Potential Output
*Krugman
Economic Growth Shifts the LRAS Curve
Rightward
*Krugman
From the Short Run to the Long Run
*Krugman
Shifts of the SRAS Curve
*Krugman
Short-run equilibrium can change when the SRAS or AD shifts
rightward or leftward.
However, long-run equilibrium of LRAS only changes when the
LRAS curve shifts.
Economists anticipate many of the
supply and demand changes.
Whenever the changes are not
expected, economists call them
SHOCKS.
A DEMAND SHOCK is an event
that shifts the aggregate demand
curve. An example of a negative
demand shock is the Great
Depression. An example of a
positive demand shock is the
increase in government
purchases during World War II.
LRAS
P
R
I
C
E
SRAS
L PL0
E
V
E
L
AD
RGDPF
E
Real Gross
Domestic Product
Short-Run Versus Long-Run Effects of a Negative
Demand Shock
*Krugman
Short-Run Versus Long-Run Effects of a Positive
Demand Shock
*Krugman
Negative Supply Shocks
*Krugman
Another way of
viewing Aggregate
Supply (in the
combined Classical
model/Keynesian
model) is to divide the
curve into three segments:
•Horizontal Range (ab)
•Intermediate Range (bc)
•Vertical Range (cd)
d
P
R
I
C
E
L
E
V
E
L
S
Intermediate
range (Shortrun)
a
Vertical
range (longrun)
c
b
Horizontal range
QU
QF QC
Real Gross Domestic Product
HORIZONTAL RANGE: (ab) includes
only real levels of output which are
substantially less than the fullemployment output (QF). This country:
•is in a severe recession or depression
• large amounts of unused machinery ,
equipment, unemployed workers .
d
P
R
I
C
E
L
E
V
E
L
S
Intermediate
range (Shortrun)
a
Vertical
range (longrun)
c
b
Horizontal range
QU
QF QC
Real Gross Domestic Product
d
VERTICAL RANGE: (cd) the
economy reaches its full-capacity real
output at QC. This economy is:
P
R
I
C
E
Intermediate
range (Shortrun)
•operating at its full capacity.
*Individual firms may try to expand
production by bidding resources away
from other firms.
*This bidding will raise resource prices
and costs and ultimately product
prices, but real output will remain
unchanged. This is an
INFLATIONARY period.
L
E
V
E
L
S
a
Vertical
range (longrun)
c
b
Horizontal range
QU
QF QC
Real Gross Domestic Product
INTERMEDIATE RANGE: (bc)
between QU and QC , an expansion of
real output is accompanied by a rising
price level.
The aggregate economy is
made up of innumerable
product and resource
markets, and full
employment is not reached
evenly or simultaneously in
the various sectors or
industries.
d
P
R
I
C
E
L
E
V
E
L
S
Intermediate
range (Shortrun)
a
Vertical
range (longrun)
c
b
Horizontal range
QU
QF QC
Real Gross Domestic Product
In the intermediate range of
aggregate supply, per-unit
production costs rise and firms
must receive higher product prices
for their output to be profitable. In
this range, rising real output is
accompanied by an increasing
price level.
When discussing the shape of
the aggregate supply curve, it is
revealed that real output
increases as the economy
moves from left to right through
the horizontal ranges of
aggregate supply. These
changes result from movements
ALONG the aggregate supply
curve
and must be distinguished
from shifts of the curve itself.
P
R
I
C
E
L
E
V
E
L
S
Real Gross Domestic Product
An existing aggregate
supply curve identifies the
relationship between the
price level and real output,
other things being equal.
Another way of looking at Macroeconomic Equilibrium:
As in the case of the intersection of a product’s demand curve
and a product’s supply curve, we can see that the intersection of
the aggregate supply curve and the aggregate demand curve
determines the economy’s EQUILIBRIUM PRICE LEVEL
and EQUILIBRIUM REAL DOMESTIC OUTPUT.
P
R
I
C
E
AS
L
E
V
E
L
Real Domestic Output, GDP
Equilibrium in the
intermediate range
of aggregate
supply.
A
D
P
R
I
C
E
L
E
V
E
L
AS
Equilibrium in the
horizontal range
of aggregate
supply.
A
DGDP
Real Domestic Output,
Where equilibrium occurs in
the horizontal range of
aggregate supply, no change
in the price level accompanies
the move toward equilibrium
real output.
Where equilibrium occurs in
the intermediate range of
aggregate supply, the price
level will change to eliminate
underproduction or
overproduction of output.
P
R
I
C
E
AS
L Pe
E
P
V 1
E
L
Q1 Qe Q2
Real Domestic Output, GDP
AS
P
R
I
C
E
A
D
L
E Pe
V
E
L
Q1 Qe Q2
A
D
Real Domestic Output, GDP
The effect of an increase in aggregate demand depends upon the
range of the aggregate supply curve in which it occurs.
An increase in aggregate demand
during the horizontal range increases
the real output but leaves price
unaffected.
AS
P
R
I
C
E
L
E P1
V
E
L
AD2
AD1
Q1
Q2
Real Domestic Output, GDP
An increase in aggregate demand
during the vertical range increases
the price level but production cannot
exceed capacity.
AS
P
R P6
I
CP
5
E
AD6
AD5
L
E
V
E
L
Qc
Real Domestic Output, GDP
An increase in aggregate demand
during the intermediate range
increases both real output and price.
AS
P
R
I
C
E
P4
LP
E 3
V
E
L
AD4
AD3
Q3 Q4
Real Domestic Output, GDP
INFLATION AND THE MULTIPLIER
In comparing the figures below, one can see that GDP increase more in figure A
than in figure C, even though the shifts in AD are of equal magnitudes.
When we combine the two figures we will get……..
AS
P
R
I
C
E
AS
P
R
I
C
E
P4
L
E P1
V
E
L
AD2
AD1
Q1
Q2
Real Domestic Output, GDP
LP
E 3
V
E
L
AD4
AD3
Q3 Q4
Real Domestic Output, GDP
An increase in aggregate demand during the horizontal range (AD1 to AD2)
means that the economy is in recession…..excess production capacity and a
high unemployment rate. Businesses are willing to produce more output at
existing prices.
An initial change in spending and resulting change in aggregate demand transmits
fully into a change in real GDP and employment. The price level remains constant.
P
R
I
C
E
AS
P2
In the horizontal range of
aggregate supply a “fullstrength” multiplier is at
work.
FULL
MULTIPLIER
EFFECT
L
E P1
V
E
L
AD3
AD1
GDP1
GDP2
Real Domestic Output, GDP
AD2
GDP3
If the economy is in either the intermediate or vertical range of the aggregate
supply curve, part or all of any initial increase in aggregate demand will be
dissipated in inflation and therefore NOT be reflected in increased real output
and employment.
Below, the shift from AD2 to AD3 is of the same magnitude as AD1 to AD2.
Because we are in the intermediate range of the aggregate supply curve, a portion
of the increase in aggregate demand is absorbed as inflation as the price level rises
from P1 to P2.
Real GDP rises only to GDP’.
P
R
I
C
E
AS
P2
If the aggregate supply curve
had been horizontal, then the
shift would have increased real
GDP to GDP3.
FULL
MULTIPLIER
EFFECT
L
E P1
V
E
L
AD3
AD1
GDP1
AD2
REDUCED
MULTIPLIER
EFFECT
GDP2 GDP3
Real Domestic Output, GDP GDP’
THE RATCHET EFFECT
What happens when aggregate demand decreases??
Our model suggests the following:
Horizontal Range: Real GDP falls
and price level remains
unchanged.
Vertical Range: Prices fall and
real output remains at the fullcapacity level.
Intermediate Range: Both real
output and price level diminishes.
The complication is that many prices (of both products and
resources) rise quickly but are “sticky” or inflexible in a
downward direction. Some economists call this the
“ratchet effect’ because a ratchet is a mechanism that
cranks a wheel forward but not backward.
P
R
I
C
E
AS
P
R P6
I
CP
5
E
P4
LP
E 3
V
E
L
AD4
AD3
AD6
AD5
L
E
V
E
L
Q3 Q4
Qc
Real Domestic Output, GDP
Real Domestic Output, GDP
If AD increases from AD1 to AD2 the economy moves from P1Q1
equilibrium (point a) on the horizontal range to P2Qc equilibrium (point b)
on the vertical range.
This increase in aggregate demand has increased the price level.
The higher product prices in turn result in increases in wages and
increased input prices, raising per-unit production costs at each level
of available GDP.
These prices, however, do not
come down very easily. Instead
of the economy returning to
equilibrium at point a, the higher
per-unit costs remain and the
aggregate supply curve will stay
in place at P2cAS (point c).
AS
P
R
I
C
E
c
P2
b
AD2
a
LP
E 1
V
E
L
AD1
Q2
Q1
Qc
Real Domestic Output, GDP
REASONS for DOWNWARD PRICE-LEVEL INFLEXIBILITY
1) Wage Contracts: Unions prohibit wage cuts for duration of the
contract.
2) Morale, Effort, and Productivity: Lower wages may reduce
worker morale and work effort, lowering productivity.
3) Training Investments: Lowering wages may cause skilled
workers to quit and costs would be incurred to train the new workers.
4) Minimum Wage: Legal floor for wages for lesser skilled workers.
5) Menu Costs: The cost of changing prices (reprinting of menus &
catalogs, advertising, etc.)
6) Fear of Price Wars: Concern that if one business lowers their
prices, rivals will cut with deeper and deeper rounds of price cuts.
DEMAND-PULL INFLATION
…..is when the price level rises as a result of an increase
in aggregate demand.
An increase in consumer optimism could spur an increase in
aggregate demand. This would cause an increase in the price level
and an increase in real output.
Remember, businesses have an
incentive to produce more when the
prices of their goods are rising faster
than the costs of inputs.
Is it possible for production to
exceed its potential?
Yes….for a short time. As workers
are encouraged to work overtime
and part-time workers become fulltime.
P
R
I
C
E PL2
LRAS
SRAS1
SRAS0
c
b
PL1
L
E PL0
V
E
L
S
a
AD1
AD0
RGDPF
Real GrossE Domestic Product
COST-PUSH INFLATION
What would happen if OPEC were to impose steep price
increases on oil like they did in 1973-74???
The domestic per-unit price of producing goods would
increase and drive prices up. This is what is called COSTPUSH INFLATION.
A shift from SRAS0 to
SRAS1 would cause the
economy to move from
point a to b. Cost-push
inflation increases from P1
to P2 and real output from
RGDPFE to RGDP1.
LRAS
P
R
I
C
E
SRAS1
SRAS0
P2
b
L
E P1
V
E
L
S
a
A
D
RGDP1 RGDPF
E
Real Gross Domestic Product
When OPEC imposed steep price increases on oil in 1973-74,
it caused a phenomenon known as STAGFLATION
through the 1970s and 80s. This is where lower growth and
higher prices occur together and shown below by a leftward
shift in the Aggregate Supply Curve.
When the Aggregate
Demand Curve does not
change and price level
increases, then inflation is
caused by supply-side
forces, not demand.
LRAS
P
R
I
C
E
SRAS1
SRAS0
P2
b
L
E P1
V
E
L
S
a
A
D
RGDP1 RGDPF
E
Real Gross Domestic Product
CLASSICAL vs KEYNESIAN AGGREGATE SUPPLY
KRUGMAN’S
Chapter 28
Income and
Expenditure Approach
What you will learn in this chapter:
The meaning of the consumption function, which shows
how disposable income affects consumer spending
How expected future income and aggregate wealth affect
consumer spending
The determinants of investment spending, and the
distinction between planned investment and
unplanned inventory investment
How the inventory adjustment process moves the
economy to a new equilibrium after a demand shock
Why investment spending is considered a leading indicator
of the future state of the economy
Disposable Income and Consumer Spending for
American Households in 2003
*Krugman
The Consumption Function
The Aggregate Consumption Function
*Krugman
An Upwards Shift of the Aggregate
Consumption Function
*Krugman
A Downwards Shift of the Aggregate
Consumption Function
*Krugman
Fluctuations in Investment
Spending and Consumer Spending
Planned Aggregate Spending
and GDP
GDP = C + I
YD = GDP
C = A + MPC – YD
AEPlanned = C + IPlanned
Planned aggregate spending is the total amount
of planned spending in the economy.
Planned Aggregate Spending and GDP
Income-Expenditure Equilibrium
The economy is in income–expenditure equilibrium
when GDP is equal to planned aggregate spending.
Income–expenditure equilibrium GDP is the level of
GDP at which GDP equals planned aggregate spending.
Income-Expenditure Equilibrium
*Krugman
The Multiplier Process and Inventory
Adjustment
*Krugman
The Multiplier Process and Inventory Adjustment
*Krugman
The Paradox of Thrift
In the Paradox of Thrift, households and producers cut
their spending in anticipation of future tough economic
times.
It is called a paradox because what’s usually “good”
(saving to provide for your family in hard times) is
“bad” (because it can make everyone worse off).
Aggregate expenditures schedule will rise when the
price level declines and fall when the price level
increases.
A
g
g
r
e
g
a
t
e
E
x
p
e
n
d
i
t
u
r
e
s
3
(Ca + Ig + Xn + G)3 at P3
(Ca + Ig + Xn + G)1 at P1
(Ca + Ig + Xn + G)2 at P2
1
2
450
GDP2 GDP1
GDP3
Real Domestic Output, GDP
*McConnell, Brue
Compare the GDP at each level.
A
g
g
r
e
g
a
t
e
E
x
p
e
n
d
i
t
u
r
e
s
P3
3
P1
P2
1
P
r
i P2
c
e
2
1
P
L 1
e
v
P
e 3
l
2
3
AD
450
GDP2
GDP1
GDP3
Real Domestic Output, GDP
GDP2 GDP1
GDP3
Real Domestic Output, GDP
*McConnell, Brue
Compiled by:
Virginia H. Meachum, Economics Teacher
Coral Springs High School
Sources:
Principles, Problems, and Policies, by Campbell McConnell &
Stanley Brue
Economics, by Krugman, Wells
Principles of Economics, by N. Gregory Mankiw
Notes by Florida Council on Economic Education and FAU
Center for Economic Education
Notes by Foundation for Teaching Economics