AGGREGATE SUPPLY

ECONOMY AT POTENTIAL GROSS DOMESTIC PRODUCT MICROECONOMIC VIEW:

THE ECONOMY IS ON THE PRODUCTION POSSIBILITY BOUNDARYFIRMS TEND TO BE IN

LONG-RUN EQUILIBRIUM

BUT IF DEMAND INCREASES, FIRMS CAN EXPAND OUTPUT. IF COSTS DO NOT CHANGE, BUT OUTPUT PRICE OR QUANTITY DEMANDED RISES, FIRMS WILL EXPAND PRODUCTION. MICROECONOMIC VIEW OF AN ECONOMY AT POTENTIAL GROSS DOMESTIC PRODUCTION

THE POTENTIAL GDP IS INDEPENDENT OF THE PRICE LEVEL. IN THE LONG-RUN. ALL PRICES ADJUST (output and wages and inputs) AND ECONOMY IS AGAIN AT CAPACITY. IN THE SHORT-RUN: If output prices rise, firms will produce more. Firms will operate beyond minATC. Workers will work overtime. Unemployment will fall. The participation rate may rise above the normal level. Wages and other input prices are slower to adjust than output prices, so many firms will find demand and prices rising faster than their costs.

IN THE SHORT-RUN: In response to rising output prices, production expands. The economy, for a while operates beyond its PPB. In response to falling output prices, production contracts. The economy, for a while operates inside its PPB. The economy moves along the SAS not the LAS

Note that since prices and demand are falling for the entire economy, not just in one industry, that the demand for labour and total employment opportunities are affected. IN THE LONG-RUN: If output prices rise, rising demand for workers and for other inputs will drive up wages. Costs of firms will rise. They will no longer wish to produce more than capacity output.

When wages and other input costs have risen as much as output prices, the economy returns to capacity. In the short-run we can produce beyond capacity and employ more workers for longer hours than they normally wish to work. In the long-run, wages and other prices will rise.

In the long-run the SAS will shift. Whenever wages rise, the SAS shifts up. Firms require higher prices to produce the same output. SAS shows the change in output when output prices rise but wages are constant. In the long-run rising output prices make wages rise. When wages rise, the SAS shifts up. LAS shows long-run potential GDP. Firms are at capacity, participation rates, over time, unemployment are at normal levels. LAS does not change with price level. IN THE SHORT-RUN: If demand and output prices fall, firms will operate below capacity. They will produce less output than where ATC is a minimum. Workers will work short-time or will be laid off. Unemployment will rise.

Note that since prices and demand are falling for the entire economy, not just in one industry, that the demand for labour and total employment opportunities are affected. IN THE LONG-RUN: If output prices fall, falling demand for workers and for other inputs will drive down wages. Costs of firms will fall. They will no longer wish to produce less than capacity output. The increase in demand is occurring throughout the economy, so that wages are affected. If wages fall, the SAS will shift down. SAS would shift from SAS2 (red) to SAS (blue)
0

BUT WORKERS HATE WAGE CUTS. Wages are very slow to fall. Waiting for this process to occur led Keynes to quip In the long-run we are all dead. IN THE VERY LONG-RUN: 5

The LAS can shift due to economic growth. The same forces that shift out the PPB will shift the LAS to the right. Disasters such as wars or earthquakes can also shift the LAS in to the left. When the LAS shifts, it shifts the SAS along with it. Think of it as if the SAS is linked to the LAS with a ring. The SAS can slide up and down the LAS, but if the LAS moves, so does the SAS.

Potential GDP changes, for three reasons Change in the full-employment quantity of labour Change in the quantity of capital (physical or human) Advance in technology