Aggregate Supply

Aggregate supply refers to the supply of all goods and services produced in the United States.
The graph below shows the aggregate supply curve. The graph tells us that, as the prices of all
goods and services (the GDP Deflator) rise (fall), the supply of all goods and services
(aggregate supply) will rise (fall).
GDP Deflator
Aggregate Supply

Real GDP

Notice that this aggregate supply curve looks just like the supply curve for an individual
product. Again, this is convenient. But, again, one does not follow from the other. The reasons
for the upward slope of the aggregate supply curve (that is, for the fact that companies will sell
more of all goods and services if the prices of all goods and services rise) will be explained in
Chapters 23 and 24.
There is some disagreement about the shape of this aggregate supply curve. Some people
believe that the aggregate supply curve is actually vertical, as shown below.

GDP Deflator
Aggregate Supply

Q*

Real GDP

According to this graph, the quantity of all goods produced in the United States will be the same
whether the prices of these goods rise or fall. The quantity that will remain unchanged (Q*) is
the Potential Real GDP. As you learned in Chapter 2, the Potential Real GDP is the amount of
production necessary to have full-employment (the natural rate of unemployment). Today, we
think this means the amount of production necessary to generate enough jobs so that the
unemployment rate is only 4%. Those who argue that the aggregate supply curve is vertical
believe that the economy will always be able to maintain the Potential Real GDP (the economy
will never experience a recessionary or inflationary gap). We will consider this argument later.
But in this chapter, we will assume that the graph looks like the upward-sloping one above. With
this graph, there is much we can explain.
The Aggregate Supply graph operates in the same manner as the other graphs. What will
cause a movement along the aggregate supply curve? The answer is a change in the prices of
all goods and services produced in the United States (that is, in the GDP Deflator). What will
cause a shift in the aggregate supply curve? The answer is a change in anything other than the
prices of all goods and services produced in the United States. In this course, we will focus on
only one factor that will shift the aggregate supply curve --- a change in the costs of production.
Any change that increases costs of production will decrease aggregate supply, shifting the
aggregate supply curve to the left. Any change that decreases costs of production will increase
aggregate supply, shifting the aggregate supply curve to the right.
Aggregate Supply Curve
1. AS-illustrates the relationship between changes in output and the price level does so from a
firms or production point of view. Measures the relative relationship of real GDP and what
producers are willing and able to supply at different price level.
2. Basic Assumptions:
(a) Price is a function of costs: So we assume that price is just some percent of costs. We then
realize that overall we could get some average measure of mark up costs in the economy and that
this overall percent is slow to change.
So an example is P = 1.2C or price is 120% of costs
-if Price level units costs (and vice versa)
(b) We then note that as output (GDP) increases then unit costs increase (due to the increase in
demand for these goods; it can be thought of as a price of resources up)
- if GDP units costs (and vice versa)
Combining the two we note that: GDP units costs P-level
This gives is the relationship that we want for overall aggregate output and price level.

(c) Graphically:
Aggregate Supply Curve:
AS

Price Level

For a (-)
change

P2
P1

For a (+)
change
GDP

GDP 1
GDP 2
3. Changes in AS
-when we get things that change units costs other than output we get shifters in the AS so
changing output or price level with their corresponding changes in unit costs are movers.
Shifters:
(a) changes in oil prices
(b) changes in weather
(c) technology changes
(d) adjustments to LR of wages and other determinants of units costs that we defined earlier as
slow to change
4. Ranges/Shape/Views of Aggregate Supply
a. Keynesian View They believe in a horizontal AS curve b/c when the economy is below FE
when AD shifts out the major effects are:
i. Increase in real GDP
ii. Unemployment drops
iii. Price level is constant
*so it means that Demand creates Supply
b. Classical View In the LR the AS curve is vertical b/c the only effects of an increase in AD
when we are already at FE are:
i. Increase in P-level
**This implies Supply creates its own Demand (Says Law)
Note: This is why Keynes model is generally used to explain SR dynamics in the economy and
the Classical view is a better tool for the LR.
c. Intermediate Range when the AS is in between the Keynesian and Classical range. When
this occurs as AS shifts out, both GDP and price level increase.

Graphically:

AS

P-Level

Classical
Range
Intermediate
GDP
Keynesian
Range
C. Equilibrium
1. Def: this is where AD = AS. The price at which all suppliers want to supply at corresponds
to the price level that demands are demanding at. It is equilibrium in price level and output.
At equilibrium we find the price level that AD = AS
Note:
(1)At GDP 1 this is not equilibrium because AD > AS. As this price level suppliers want to
increase prices reduce AD get use back to Equilibrium.
(2) Equilibrium GDP might not be FE-GDP. This needs to be compared to FE levels.
(3) We can get macro shocks that take us away from levels that are already at FE levels.
Graphically: Price
Level

AS

PE

AD

GDPE

GDP1

GDP

Recall - changes in price level are also called inflation when they are calculated as rates of
changes in price level from one year to the next.
2. Disequilibria:

Price
Level

AS

PE

AD
GDP
GDP1: This is not equilibrium
level
GDP1 because
GDPE at thisGDP
2 of GDP consumers would be willing to pay a
higher price and there would be a drop in inventories. So, there would be an increase in output
and an increase in price level to PE.

GDP2: This is not equilibrium because at this level of GDP consumers would not be willing to
pay a higher price and there would be an increase in inventories. Suppliers would be charging to
high of a price overall in the economy. So, there would be a decrease in output and a decrease in
price level until we go to PE.
3. Shifts of AD or AS
a. Shifts in AD Recall that to get a change in AD we would need something to change spending
holding price level constant. Our examples before were monetary and fiscal policy and other
AE spending changes.
Consider an increase in AD
Graphically: Price
Level

AS

PE2

PE
AD2
AD1
GDP
GDP E1

GDP E2

GD

-We can see that if AD shifts out we get an increase in GDP, but we also get an increase in Plevel. This is inflationary. So we see that to get growth through an increase in spending results
in inflation. This is why the FED closely monitors inflation upon engaging in its policy or when

it notices that there have been unusually high spending levels in the economy. They want to
make sure that there is controlled/contained growth.
Note: that the opposite results hold. So if we had AD P Level & GDP
b. Shifts in AS or Supply Shocks. Recall that for supply to change we get change in things that
affect unit costs overall in the economy without really affecting GDP. Many of these items
(weather, technology, war, price of oil, etc...) are not something that can be predicted or
controlled. So, they are called shocks. If we get a (-) change in AS the results are as follows:
Graphically: Price
Level

AS2
AS1

E2

PE1
AD
GDP
GDP E2

GDP E1

GD

-so we can see here that a negative supply shock results in a drop in GDP and an increase in price
level. These are two bad effects in the economy overall. So when we had a natural disaster like
hurricane Katrina, steps were taken in order to minimize these effects. Two things that can be
done are:
(1) FED engage in expansionary policy (increase money supply) in order to help GDP get back
to previous levels and probably increase.
(2) Federal Government engage in expansionary fiscal policy by increasing G or decreasing
taxes. By doing this spending should increase which would also help GDP grow.
Both of these types of policy measures will generally help GDP grow again, but even if that
occurs the price level in the economy is most likely going to rise due to the supply shock. We
can see this in the graph below.
Graphically: Price
Level

AS2

PE3

AS1

PE2
PE1

AD2
AD1

GDP
GDP

E2

GDP

E1

GD

-we can see that with AD shifting from AD1 to AD2 with either monetary or fiscal policy (or
both working in tandem) that the economy does get back to GDPE1, but it is at the expense of a
higher price level.

D. Synopsis of A-C and Explanation of Business Cycle and AD/AS (29.4)

Topic 1: Aggregate Supply and Aggregate Demand at Equilibrium
1. Recall from before how we defined and derived our AD/AS curves. Both show us a
relationship between P-level and Real GDP.
(a) AD Shifts:
Price Level

AS

P2
P1
AD2
AD1
GDP

GDP 1 GDP 2
Overall Effect: AD P-level Real GDP
Recall that our shifters which cause this are:
i) Wealth
ii) Expectations (of future income or prices)
iii)Taxes or G Fiscal Policy
iv) Monetary Policy Changes in interest rate
v) Any changes in spending (IP or NX)
* opposite cases are true
(b) Changes in AS:
Price
Level

AS1
AS2

P1
P2
AD
GDP
GDP 1

GDP 2

GD

Overall Effect: AS P-level Real GDP

Recall that our shifters which cause this are all essentially temporary things or shocks. For this
reason we will assume that for the most part that we cannot control the shifts of AS.
-note that we get an upward sloping line to due wage stickiness. If the wages were completely
flexible then unit costs would change more readily. We will illustrate this in our comparison
with SR vs. LR.
i) Wages
ii) Price of non-labor inputs
iii)Productivity changes Changes in K or Technology
iv) Supply Shocks such as weather, natural disasters, and wars
v) Subsidies or government regulation that a affects business environment
* opposite cases are true
(c) LRAS or Potential GDP
For the long run we assume that there is perfect wage flexibility and that our economy has
moved to its LR levels in all relevant markets. We also assume that the economy in terms of
production and consumption moves to levels that are consistent with the levels that are currently
possible in the economy w/o over consuming or producing in the SR.
It is sometimes called the natural rate (NR) or full-employment (FE) levels in the economy.
Graph 1:

Price-Level

LRAS

P1

AD
GDP
GDP NR

GD

Note: The economy is in LR equilibrium when the AD and LRAS curve intersect. At this time
we say that we are operating at FE or natural rate in the economy. It is not always the case that
this occurs. Consider the two cases below when we have instances where the economy is
operating above or below the NR.
Classical View: The view that our economy should be in the LR equilibrium at all times if the
government doesnt interrupt the private market is called the classical view. They propose that
the economy self-corrects (which will be shown to be true) so it is best to leave the markets
alone. This might be the case in the LR, but in the meantime when there is unemployment or
inflation we as a society want to use corrective measures to assist the overall macroeconomy.
The reason we get this in the economy is called.
Says Law- Supply creates its own demand. Because this is the case, if we get that all funds are
eventually spent and all G/S are eventually purchased, we should have an efficiently operating
economy that has no excess inventories or shortage of inventories.
This implies that our production, or GDP, should be at efficient levels.
Note: The Great Depression dispelled this notion that we should just let our economy operate
with no intermediation. This is called Laissez-Faire or hands off approach when monitoring the
economy
Case 1: Operating above the FE in the SR Inflationary Gap
Price-Level

AS2

LRAS

AS1
P2

Inflationary Gap

P1

AD
GDP
GDPFE

GDPSR

GD

In this instance we can see that GDP-SR > GDP-FE. This means the economy is in a surplus. So
we will have inflation because the price level will rise and employment level will decrease as we
move back to our FE level of GDP.
Case 2: Operating below FE in the SR Recessionary Gap
Price-Level

LRAS

AS1
AS2

P2

Recessionary Gap

P1

AD
GDP
GDPSR

GDPFE

In this instance we can see that GDP-SR < GDP-FE. This means the economy is in a deficit or
recession. So we will have a drop in price level because the price level will decrease as AS
adjusts and employment level will increase as we move back to our NR level of GDP.
Case 3: SR and LR are the same
LRAS

AS

P2
P1

AD
GDP
GDP FE

GD

In this instance the intersection of all 3 graphs are the same and the economy is at the FE or FE
level, so dont do anything since the economy is operating right at its potential.
Topic 2: Self-Regulating Economy
Note that in the above cases we have the AS curve shifting in order to bring us back into the NR
or LR equilibrium. This is due to self-regulating that occurs automatically in the labor market.
What this means is that nothing needs to be done from a governmental point of view in order to
bring the economy back to our LR values. This is the classical view of things.
1. Inflationary Gap Adjustment This is what happens to get us back to FE-levels with the AS
curve if there is an inflationary Gap.
(a) Current Unemployment < NR Unemployment This implies that too many people are
working. In this case we get a shortage in the labor market.
(b) Shortage in Labor market causes wages to rise.
Labor Market: Excess Demand
Wages
WE

S
Shortage or Excess Demand

D
Ls

Labor

Ld

If the wage were lower than WE , as we have shown above, then there would be a shortage in the market.
Producers would increase the wage until they got back to WE.

(c) So if this occurs this shifts our AS to the left like in Case 1 above and we get back to our LR
equilibrium
2. Recessionary Gap Adjustment This is what happens to get us back to FE-levels with the
AS curve if there is a recessionary gap as in Case 2 above
(a) Current Unemployment > NR Unemployment This implies that too few people are
working. In this case we get a surplus in the labor market.
(b) Surplus in Labor market causes wages to fall.
Labor Market: Excess Demand
Wages

S
Surplus or Excess Supply

WE

D
Ls

Ld

Labor

If the wage were higher than WE , as we have shown above, then there would be a surplus in the market.
Producers would decrease the wage until they got back to WE. This makes intuitive sense b/c in a
recession producers are able to offer lower wages in order to higher more workers.

(c) So if this occurs this shifts our AS to the right like in case 1 above and we get back to our LR
equilibrium
Topic 3: Fiscal Policy and Results
Although there is a self-regulating economy for the most part economists and government dont
want to sit back and wait until the economy self-adjusts to get back to equilibrium. So what can
we do? We can alter taxes or G in order to get back to GDP-FE. This is what was proposed by
John Maynard Keynes in the 1930s in order to alleviate the problems with overall output.
Note: The models used here were discussed in the notes as Consumption Function and
Aggregate Expenditure Model. In this we had MPC and the money multiplier. I am not going to

cover that since the notes already do. What I do want to cover is simply the method proposed by
Keynes in general. So see worksheets and notes for specific examples.

Case 1: Recessionary Gap

AS1

LRAS
P2
P1

AD2
AD1
GDP SR

GDP FE

GDP

GD

So as we can see what we can do is increase G or decrease Taxes in order to get a rightward shift
of AD to bring us back to GDP-FE. What is the result? It is a higher price-level, which is a
trade-off, but this is something that can be done immediately and this will serve to reduce
unemployment. So instead of waiting until internal market forces solve the issue, the
government can be proactive and alleviate it. [note: In the coming weeks we will discuss how the
FED can do this as well Monetary Policy].
Case 2: Inflationary Gap
LRAS
AS1
P1
P2

AD1
AD2
GDPFE

GDPSR

GDP

GD

So as we can see what we can do is decrease G or increase Taxes in order to get a leftward shift
of AD to bring us back to GDP-FE. What is the result? It is a lower price-level and
consequently a lower output level. So in this case we get that unemployment goes up, but it is
back to our NR or unemployment or FE. This is still a trade-off since there will be people who
were working who are not now due to the policy. Once again instead of waiting until internal

market forces solve the issue, the government can be proactive and alleviate it. [note: In the
coming weeks we will discuss how the FED can do this as well Monetary Policy].