Aggregate Supply Chapter 10: “The Aggregate Supply Curve”

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.  Stock of capital  State of Technology  Producer’s expectations

Aggregate Supply Describes the relationship between the price index and the Quantity of goods and services (Real GDP) supplied Holding all other determinants of supply constant The AS line is drawn assuming constant: Wages, prices of inputs, stock of capital, technology and expectations

Labor costs  Wages change when labor contracts expire.  Workers are reluctant to accept lower wages.  Employers prefer to fire unskilled workers to reduce wages of skilled workers: Reduce worker turnover: workers eager to keep their jobs. Reduces cost of inexperience and training. Increases productivity: workers work harder.  Minimum wage laws prevent wages from falling.  Unions increase worker’s bargaining power workers earn between 10 to 20% more than similar non-union workers. Wages are “sticky” in the short run Labor costs are constant in the short run

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.

 Labor is the largest cost of production If prices rise while wages remain fixed, production becomes more profitable and firms produce more. Firms maximize Profits Profit = Price - Cost same Wages are constant in the short run

Aggregate Supply Curves Slopes Upward Price Level Real GDP supplied AS Profits increase, if WAGES do not increase Firms will produce more when prices increase if profits increase Profit = Price - Cost same AS(Wage 0 )AS(Wage fixed ) Cause Effect

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  Stock of capital and labor force.  Technology/Producti vity Firms produce less when their labor costs increase: AS shifts left Firms produce more with a larger labor force or a larger stock of physical capital: AS shifts right Firms produce more with better technology: AS shifts right. Inverse Direct Factors that affect Supply Factors that shift Aggregate Supply

An increase in wages shifts AS left Price Level Real GDP supplied Profit = Price - Cost same AS(Wage 0 ) AS(Wage 1 ) P0P0 Y1Y1 Y0Y0 Firms produce LESS when wages increase

Improvements in technology, increase in Stock of Capital & labor force Price Level Real GDP supplied AS 0 AS 1 P0P0 Y1Y1 Y0Y0 Firms produce MORE with better technology, larger labor force and stock of capital

13 Po Goods and Services Purchased AD = C + I + G + NX GDPo Aggregate Demand Price Level Real GDP Higher Demand when Prices drop P1 GDP1

What Causes Inflation/Deflation? Prices change when Aggregate Demand for goods and services runs ahead or lags behind Production of goods and services (Aggregate Supply) 14

Increase Production 15 Po GDPo Aggregate Supply Aggregate Demand P1 GDP1 Supply larger than Demand: Inventories rise, Firms cut prices Produce More DemandSupplyGDPo Supply

Deflation  Before 1930 deflation was as likely as inflation.  Deflation is harmless even good, if lower prices increase real incomes and spending power. In the last 30 years of the 19th century, consumer prices fell by almost half as the expansion of railways and advances in industrial technology brought cheaper ways to make everything. Annual real GDP GROWTH over the period averaged more than 4%. 16

Deflation is dangerous when it reflects  A sharp drop in DEMAND,  Excess CAPACITY and  Decrease in GDP As in the Great DEPRESSION of the early 1930s. 17

18 Po Goods and Services Produced Goods and Services Purchased Aggregate Demand Aggregate Supply GDPo Aggregate Supply – Aggregate Demand Price Level Real GDP At this price level Aggregate Supply = Aggregate Demand At this price level all production is sold: no accumulation of inventories

AS AD In the graph above, if the price level is 120, the quantity of goods demanded is ______ the quantity of goods supplied is ______. Inventories will __________, firms will react to this change in inventories by _______________ production and ______prices. 2.In the graph above, if the price level is 140, the quantity of goods demanded is ______ the quantity of goods supplied is _______. Inventories will __________, firms will react to this change in inventories by _______________ production and ______prices. 3.For the economy in the graph above, we expect GDP to be _________and the price level to be_______________

Cost of Production Wages and prices of inputs (oil) Size of stock of capital and labor force Technology Firms produce less when costs increase AS shifts left Firms produce more with a larger labor force or a larger stock of physical capital: AS shifts right Firms produce more with better technology: AS shifts right. Factors that affect Supply Increase Improvement

22 Po Goods and Services Purchased AD = C + I + G + NX GDPo Factors that affect Demand Price Level Real GDP Demand increases when Prices drop: Move Along P1 GDP1 Demand Shifts when C, I, G NX Increase AD = C + I + G + NX

‘Good’ Inflation 23 CPIo Goods and Services Produced Goods and Services Purchased CPI1 Aggregate Demand Aggregate Supply Optimistic consumers buy more goods and services Inflation Demand higher than Supply: Inventories Drop, prices and output rise Buy More Unemployment drops GDPoGDP1 Supply Demand Growth

Bad Inflation 24 CPIo Goods and Services Produced Goods and Services Purchased CPI1 Aggregate Demand Aggregate Supply Firms can not get loans Inflation Demand higher than Supply: Inventories Drop, prices rise, output drops Produce Less Stagflation Stagflation Supply Demand Recession Unemployment increases GDPo GDP1

Good Deflation 25 CPIo GDPo Aggregate Supply Aggregate Demand CPI1 GDP1 Deflation Growth Advances in technology reduce costs Supply larger than Demand: Inventories rise, prices drop, output rises Unemployment drops Produce More

Bad Deflation 26 CPIo GDPo Goods and Services Produced Goods and Services Purchased CPI1 GDP1 Recession Consumers feel poor as real estate and stock prices fall Supply larger than Demand: Inventories rise, prices and output drop Deflation Unemployment increases Buy Less

27 Price Level Real GDP ASo AD1 ADo Price Level Real GDP ASo AS1 ADo Price Level Real GDP ASo AS1 ADo Price Level Real GDP ASo AD1 ADo Recession and deflation Recession and inflationGrowth and deflation Growth and inflation

A.Increased costs B.Increase consumption C.Increase in labor costs and increase in government spending D.Increase in wages E.Increase in labor productivity F.Lower oil prices A B C D E Which graph best describes the effect of the following events F

E2E2 E1E1 S2S2 S1S1 D1D1 D2D2 All three graphs: AS and AD increase: Depending on the relative size of the shifts, prices may go up, down or remain the same. Output definitely increase. AS shifts more than AD S2S2 S1S1 D1D1 D2D2 AD shifts more than AS S2S2 S1S1 D1D1 D2D2 AS shifts by the same amount as AD P GDP E1E1 E2E2 E1E1 E2E2