Aggregate Supply

Tells us how much is produced in goods

and services in the country.
Determinants of Aggregate Supply
Prices
Wages and prices of raw materials.
Capital stock
State of Technology
Producers expectations
Aggregate Supply
Describes the relationship between
the price level and the Quantity of
Real GDP supplied
Holding all other
determinants of
supply constant
Important Difference:
Price: what the consumer pays and the
producer receives.
Cost: what the producer pays for raw
materials, labor and other expenses
necessary to produce.
When costs rise, each unit is more expensive
to produce, the producer must raise price to
cover the increase in cost.
The change
in costs
occurs first
The change in price
occurs as a result of
the increase in cost.
Labor costs are sticky in the short run
Wages change only when labor contracts
expire.
Workers are reluctant to accept lower wages.
Employers prefer to pay higher wages:
Reduce worker turnover: workers eager to keep their
jobs .
Reduces cost of inexperience and training.
Increases productivity: workers work harder.
Minimum wage laws
Unions increase workers bargaining power:
workers earn between 10 to 20% more than
similar non-union workers.


Do not fall
quickly or easily
Firms maximize profits
Profit per unit = Price per unit Cost
per unit.
Labor is the largest cost of production
If prices rise while wages and other costs
remain fixed, production becomes more
profitable and firms produce more.
How do firms decide how much to
produce?
Profit = Price - Cost
Firms produce more
when prices increase
because profits
increase
same
The Aggregate Supply Curve slopes
upward: higher prices result in
higher production
Aggregate Supply Curves Slopes
Upward
P
r
i
c
e

L
e
v
e
l

Real GDP supplied
Aggregate Supply
The Aggregate Supply Curve slopes
upward: Firms produce more
when prices rise (assuming costs
remain the same)
Cause
Effect
Aggregate Supply Curves Slopes
Upward
P
r
i
c
e

L
e
v
e
l

Real GDP supplied
AS
Profits increase,
because WAGES
DO NOT CHANGE
Firms produce more
when prices increase
because profits increase
Profit = Price - Cost same
AS(Wage
0
) AS(Wage
fixed
)
Movement Along Aggregate Supply
When Prices increase, wages (costs)
remain constant, profits increase, firms
produce more.
When Prices decrease, wages (costs)
remain constant, profits decrease, firms
produce less.

Changes in Prices cause a movement
along Aggregate Supply
Prices
Wages and prices of
inputs
Capital stock: labor
and Physical capital

Technology/Producti
vity
AS shifts to the left:
firms produce less
when their costs
increase.
AS shifts to the right as
firms produce more
with a larger labor force
or a larger stock of
physical capital.
AS shifts to the right as
firms produce more
with better technology.
Increase
Increase
Increase
Factors that affect Supply
Factors that shift Aggregate Supply
Curve
An increase in wages shifts AS left
P
r
i
c
e

L
e
v
e
l

Real GDP supplied
Profit = Price - Cost
Firms produce LESS
when prices remain the
same and wages
increase because profit
falls
same
AS(Wage
0
)
AS(Wage
1
)
P
0

Y
1
Y
0

Determining the Price Level
The price level is the result of the
interplay between Aggregate Demand and
Aggregate Supply.
To determine the price level, we must put
Aggregate Demand and Aggregate Supply
together.
Determining the Price Level
P
0
6,000
5,600
80
100
Excess Demand: AE > Y, inventories drop, firms
increase both production and prices.
6,400
AS
AD
Y
AE
Y=AE
45
5,600 6,000
6,400
As prices rise,
real wealth
drops, C drops,
AE drops.
As prices rise,
real wealth
drops, C drops,
AD drops.
5,600
6,000
Determining the Price Level
Price
index
0
6,000
120
5,600
100
Excess Supply: AE < Y, inventories
rise, firms decrease both
production and prices
6,400
AS
AD
Y
AE
Y=AE
45
5,600
6,000 6,400
As prices drop,
real wealth
rises, C rises,
AE shifts up.
6,400
6,000
The Self Adjusting Mechanism
AD
0

P
r
i
c
e

l
e
v
e
l

P
0
5,000 4,000
AS(W
1
)
P
1

Potential GDP
Real GDP
Inflationary Gap
AS(W
2
)
Labor market shortages:
Difficult for firms to hire,
easy for workers to win
wage increases
Wages
rise: AS
shifts left
Prices rise, gap closes: purchasing power decreases AD decreases
Economys self
correcting
mechanism to close
an inflationary gap

Adjusting to a Recessionary Gap
AD
0

P
r
i
c
e

l
e
v
e
l

5,000 6,000
P
2
Potential GDP
Real GDP
Recessionary Gap
Unemployment: easy for
firms to hire, difficult for
workers to win wage
increases
Wages fall:
AS shifts
right
Prices fall, gap closes: purchasing power
increases, AD increases
AS(W
1
)
AS(W
2
)
P
1
If wages and prices do
not fall: self correcting
mechanism operates
only weakly to cure
recessions

Recessionary gaps occur
because wages and
prices do not fall.

Does the US economy has a self
correcting mechanism?
YES
When the economy experiences an inflationary
gap, wages increase, shifting the AS left,
increasing prices and thus slowing down AD.
When the economy experiences a recessionary
gap, wages decrease, shifting the AS right,
decreasing prices and thus increasing AD.

BUT
This mechanism works slowly so there is an
argument to be made in favor of stabilization
policies.
Using the Model
Stagflation from a Supply Shock: Rising
Energy Prices shift the AS left
Stagflation from a Supply Shock
AD
0

P
r
i
c
e

l
e
v
e
l

100
5,000
AS
1

P1
AS
2

Real GDP
Oil Prices rise: Cost of
production increase: AS
shifts left
Higher prices & lower
output: stagflation
Factors that shift the
consumption function
1. Changes in wealth
shift the consumption function.
Example: value of stocks, bonds,
consumer durables.
2. Changes in consumer
expectations
Shift the consumption function.
Example: Pessimistic expectations
decrease autonomous consumption.
3. Prices
Affect the purchasing power of
assets.
Shift up in AE line
Shift right in AD line
Shift up in
AE line
Movement
Along AD
line
Determinants of Investment
Interest Rates:
Tax Incentives:
Technical Change:
Expectations about the
strength of demand:
Political Stability and the rule
of law:
Shift AE line
Shift AD line
Government expenditures are
determined by the budget
process: The president,
Congress and the Senate.

Fiscal Policy
Shift AE line
Shift AD line
National Incomes
GDP of other countries
Relative Prices
Exchange Rates

Shift AE line
Shift AD line
Which graph describes the effect of an
increase in Autonomous Consumption
Near Full
employment
Below Full
Employment
Near Full
employment
Below Full
Employment
A. Increased oil
prices

B. Increase in
autonomous
consumption

C. Adverse
supply shock
with increase
in government
spending

D. Rising wage
rates

E. Increase in
labor
productivity
F. Lower wages
A B
C
D
E
Which graph best describes the effect of the
following events
F
1. Economic growth and inflation
2. Recession caused by a decrease in
consumption and increase in productivity
3. Recession &
deflation mainly
caused by drop in
AD
4.Expansion with inflation caused
mainly by increase in AD
5.Expansion with deflation
mainly caused by increase
in AS
1
2 3
4
5
5
Which graph best describes the effect of the
following events
Practice
1. What is the AS curve? What does it
represent?Draw the appropriate graph to
illustrate your answer. Be sure to label
axes and curve.
2. Distinguish between a movement along
and a shift of the AS curve. What factors
cause each to occur?
3. What causes the AS to have an upward
slope? Why does it get steeper as output
grows?
Practice
4. Explain how the economy self corrects
out of an inflationary/recessionary gap.
Why is it possible that the economy
might not self correct out of a
recessionary gap?
5. Explain why is a period of stagflation
part of the normal aftermath of a period
of excessive aggregate demand?
6. Draw both an AE 45degree line and an AS-AD diagram to
show the effect on GDP and the price level resulting from
a) Prices in the US Increase
(decrease) relative to
prices abroad.
Consumption
Exports
Imports
NX
b) Wealth Increase
(decrease)
Home prices/stock prices
collapse (increase)
c) Increase in oil prices
d) Increase in productivity
e) Increased availability of
natural resources
f) Increase in wage
g) Weaker(stronger) dollar
Exports
Imports
NX
h) Technological breakthrough
(zero emissions engine)
i) Increase in the labor force
j) Government spending increase
(decrease)
Increase/decrease in number of
troops deployed abroad
k) Interest rates Increase
(decrease)
l) Increase in the stock of capital
m) Taxes Increase (decrease)
n) Transfers Increase (decrease)

Oil Prices rise
AD
0

Price level
AS
0

P
1
AS
1

Real GDP
Cost of production increase:
AS shifts left
Higher prices & lower output:
stagflation
Potential GDP
P
0

Y
0

Y
1

At P0, AD > AS
Inventories fall
Prices rise (Up along AD)
Output fall
Recessionary
Gap
Unemployment: easy for firms
to hire, difficult for workers to
win wage increases
Wages fall: AS shifts right
Prices fall, gap closes:
purchasing power increases,
AD increases (down along AD)
45
0

C
0
+I+G+NX
C
1
+I+G+NX
Y
C
When prices increase
from P
0
to P
1
,
The AE line shifts down
The real value of wealth
decreases and
consumption decreases
from C
0
to C
1
.
The equilibrium value of
output decrease from Y
0
to
Y
1
: Move Up along AD
Y
1
Y
0

Potential GDP
Recessionary Gap
Unemployment: easy for firms
to hire, difficult for workers to
win wage increases
Wages fall, Prices fall
45
0

C
0
+I+G+NX
C
2
+I+G+NX
Y
C
When prices decrease
from P
1
back to P
0

The AE line shifts up
The real value of wealth
increase and
consumption increase
from C
0
to C
2
.
The equilibrium value of
output increase from Y
0
to
Y
2
: a move down along AD.
Y
2
Y
0

Potential GDP
Prices fall, gap closes:
purchasing power increases,
AD increases (down along AD)
Recessionary/Inflationary Gap?