Chapter Aggregate Supply and Economic Growth zThis chapter -- looks at the effects of changes in Aggregate Supply, both short-run and long-run. zCorrespondingly, we examine the causes that shift the AS curve and the LAS curve, and their effects on the economy.

Short-Run Aggregate Supply (AS) zShort-Run Aggregate Supply (AS) -- the sum of all the newly produced US final goods and services that firms wish to produce (real GDP supplied), given inflexible input prices (especially the nominal wage rate).

Short-Run Aggregate Supply (AS) -- Causes zPrice Level (P) P   AS  zPrice of Energy (P E ) P E   AS  zThe Nominal Wage Rate (W) W   AS 

Short-Run Aggregate Supply -- More Causes zLabor Productivity (PROD), defined as output per labor hour. PROD   AS  zCapital Stock (K) -- all the existing physical plant and equipment used by firms to produce goods and services. K   AS 

Formalizing the AS Curve zUpward sloping when graphed against Price Level (P). zChanges in a cause other than P -- described as shifting the AS curve. zChanges in variables that increase AS, or enhance production, shift the AS curve rightward. zChanges in variables that decrease AS, or hinder production, shift the AS curve leftward.

Example 1 -- A Supply Shock zExample 1 -- The price of energy (P E ) increases (energy crisis in US, 1973 and 1979). zP E  hinders production, reduces Short- Run Aggregate Supply. zTherefore the AS curve shifts leftward. zAs a result, Y* , P*  (Yuck!!).

Example 2 -- Productivity: The “Magic” Variable zExample 2 -- Labor productivity (PROD) increases (late 1990s, 2000 in US). zPROD  increases Short-Run Aggregate Supply. zTherefore the AS curve shifts rightward. zAs a result, Y* , P*  (Wow!!).

Example 3 -- The Wage-Price Spiral zExample 3 -- Two Changes. (1) Increases in (G - T) (increase in government purchases, or decrease in taxes) move Y* beyond Y F and accelerate inflation. (2) Labor wants their wages to keep pace with inflation, so they get larger than normal wage increases (W  ).

Describing The Wage-Price Spiral -- AD-AS Model (1) Increase in (G - T) shifts AD curve rightward, Y*  beyond Y F, P* . (2) The rise in W is described by a shift of the AS curve leftward. zAs a result Y* returns to its previous level, P*  even more. zCreates a situation called Stagflation – inflation with stagnant output. zTends to be a continuing process, i.e. “spiral”.

The Long-Run Aggregate Supply (LAS) Curve zVertical when plotted versus the price level (P). zVertical at the full sustainable level of real GDP (Y F )

Shifting the LAS Curve zCurve shifts either rightward (increase in LAS) or leftward (decrease in LAS) zVariables that shift the LAS curve rightward, therefore, increase Y F. zVariables that shift the LAS curve leftward, therefore, decrease Y F.

Shift Variables – LAS Curve (Variables That Change Y F ) zLabor Productivity (PROD) PROD   LAS  zCapital Stock (K) -- all the existing plant and equipment used by firms to produce goods and services. K   LAS 

More Shifters – LAS Curve (Variables That Change Y F ) zSize of Labor Force Labor Force   LAS  zTastes/Preferences Toward Work. Work   LAS  zTransfer Payments (TP) TP   LAS 

Application #1 – What Makes Y F Grow in the US? zSteady Growth in the Following Variables: yLabor Force yCapital Stock Accumulation yLabor Productivity zAverage Growth of Y F in US: 2.5% per year zNot the same for all countries in the world.

Application #2 – Effects of a Productivity Boom zSuppose that increased technology (e.g. computerization) makes labor more productive. zProductivity growth increases, shifts LAS curve rightward more than usual.

Application #2 Continued -- Effects on Y F zTherefore Y F in the US grows at more than 2.5%. zThis implies that actual real GDP (Y*) can enjoy higher growth without accelerating inflation. zVery nice!!

Goals for the Economy zFluctuations -- seek to get the economy (Y*) as close to possible to a given Y F (examples: standard fiscal and monetary policy)  shift AD curve. zEconomic Growth -- seek to increase the full sustainable level of real GDP (Y F )  shift LAS curve.

Ways to Increase Economic Growth (Increase Y F ) zCapital Stock  zLabor Productivity  zLabor Force  zHousehold Attitudes Toward Work  zTransfer Payments 

Trying to Increase Labor Productivity zIncrease Research and Development. zIncrease Labor Quality (Human Capital) – Education and Vocational Training. zPromote Investment (plant and equipment)!!! -- Tends to Incorporate New Technology. -- Also expands the capital stock.