1. Chapter 11
Aggregate Supply
© 2009 South-Western/ Cengage Learning

2. Aggregate Supply in the Short Run
Aggregate supply, AS
Relationship
Price level
Output firms are willing and able to supply
Constant
Resource prices
Technology
Set of formal and informal institutions
Short run
Some resource prices: fixed

3. Labor and Aggregate Supply
70% of production costs
Supply of labor
Size/abilities of adult population
Preferences for work vs. leisure
Higher wage - More labor supplied
Higher price level
The less the money wage purchase
The less attractive the wage

4. Labor and Aggregate Supply
Nominal wage
Money wage
Real wage
In constant dollars
Negotiation
Expected price level

5. Potential Output Potential output Amount produced
No surprises about price level
Maximum sustainable output
Natural rate of output
Full-employment rate of output

6. Natural Rate of Unemployment
Unemployment rate when
Potential output
No cyclical unemployment
Some frictional, structural and seasonal unemployment
4-6%

7. Actual Price Level is Higher than Expected
Price level > expected
Higher profit per unit
Increase production
Economy’s output > potential
Unemployment < natural rate
Increased per-unit production cost
Marginal cost increases
The price level rises faster

8. Actual Price Level is Lower than Expected
Price level < expected
Production less profitable
Decrease production
Economy’s output < potential
Unemployment > natural rate
Decreased per-unit production cost

9. Short-Run Aggregate Supply Curve
Short-run aggregate supply curve, SRAS
Actual price level
Real GDP supplied
Price level = as expected
AD curve intersects SRAS
Potential output
Natural rate of unemployment
Slope of SRAS curve
Increase in marginal cost

10. Exhibit 1 Short-run aggregate supply curve Potential output
The SRAS curve is based on a given expected price level, in this case, 130. Point a shows that if the actual price level equals the expected price level of 130, producers supply potential output.
If the actual price level is below 130, firms supply less than potential. Output levels that fall short of the economy’s potential are shaded red; output levels that exceed the economy’s potential are shaded blue.
Price
level
140
120
130
SRAS130 a
Real GDP
(trillions of dollars)
14.0

11. Closing an Expansionary Gap
Long run
No surprises about the price level
AD greater than expected
Short run
Price level > expected
Output > potential
Unemployment < natural rate
Expansionary gap
Inflationary pressure

12. Exhibit 2
Short-run equilibrium when the price level exceeds expectations
Expected price level=130, SRAS130 If actual price level turns out as expected, the quantity supplied = potential output of $14 trillion.
Potential
output
Price
level
140
130
135
LRAS
SRAS140
Given the AD curve, price level > expected; output exceeds potential (b); expansionary gap. AD
SRAS130 c
In the long-run, price-level expectations and nominal wages will be revised upward. Costs will rise and the SRAS curve shifts leftward to SRAS140. Eventually, the economy will move to long-run equilibrium (c), thus closing the expansionary gap. b a
Real GDP
(trillions of dollars)
14.0
14.2

13. Closing an Expansionary Gap
Long run
Higher nominal payments
Higher production costs
SRAS shifts left
Cost-push inflation
Lower output
Long run equilibrium

14. Closing an Expansionary Gap
Long run equilibrium
Expected price level = actual
Quantity supplied in SR = potential output = Quantity supplied in LR
Quantity supplied = quantity demanded

15. Closing a Contractionary Gap
AD lower than expected
Short run
Price level < expected
Output < potential
Unemployment > natural rate
Contractionary gap
Deflationary pressure

16. Exhibit 3
Short-run equilibrium when the price level is below expectations
Actual price level < expected (intersection of AD” with SRAS130); short-run equilibrium: (d). Production below economy’s potential opens a contractionary gap.
Potential
output
Price
level
130
120
125
SRAS130
LRAS
SRAS120
If prices and wages are flexible enough in the long run, nominal wages will be renegotiate lower. As resource costs fall, the short-run aggregate supply curve eventually shifts rightward to SRAS120 and the economy moves to long-run equilibrium at (e), with output increasing to the potential level of $14.0 trillion.
AD” a d e
Real GDP
(trillions of dollars)
14.0
13.8

17. Closing a Contractionary Gap
Long run
Lower nominal wages
Lower cost of production
SRAS shifts right
Deflation
Grater output
Long run equilibrium

18. Tracing Potential Output
Economy’s potential output
Long-run aggregate supply curve, LRAS
Depends on
Supply of resources in economy
Level of technology
Production incentives
Long-run equilibrium
Output = LRAS = potential output
Price level: depends on AD curve

19. Exhibit 4 Long-run aggregate supply curve Potential output LRAS
In the long run, when the actual price level equals the expected price level, the economy produces its potential. In the long-run, $14.0 trillion in real GDP will be supplied regardless of the actual price level. As long as wages and prices are flexible, the economy’s potential GDP is consistent with any price level. Thus, shifts of the aggregate demand curve will, in the long-run, not affect potential output. The long-run aggregate supply curve, LRAS, is a vertical line at potential GDP.
Price
level
140
120
130
AD’ AD
AD” b a c
Real GDP
(trillions of dollars)
14.0

20. Wage Flexibility and Employment
Expansionary gap
Labor shortage
Higher nominal wage
Higher price level
Contractionary gap
Nominal wages = “sticky” downward
Slow to close

21. US output gaps and wage flexibility
Contractionary gap
Coordination failure
“Sticky” wages downward
Negotiating long-term contracts
Costly and time consuming
Reduce frequency of strikes and lockouts
Layoffs instead of cutting nominal wages
Employers: hurts morale; reduce productivity
Unemployment benefits

22. Exhibit 5
US output gap measures actual GDP minus potential output as percentage of potential output

23. Shifts of the Aggregate Supply Curve
Aggregate supply increases, LRAS
Increased quantity and quality of labor and other resources
Institutional changes
Gradually

24. Exhibit 6
Effect of a gradual increase in resources on aggregate supply
LRAS
LRAS’
Price level
A gradual increase in the supply of resources increases the potential GDP – in this case, from $14.0 trillion to $14.5 trillion.
The long-run aggregate supply curve shifts to the right.
Real GDP
(trillions of dollars)
14.5
14.0

25. Shifts of the Aggregate Supply Curve
Supply shocks
Unexpected events
Beneficial supply shocks
Increase aggregate supply (SRAS, LRAS)
Abundant harvests
Discoveries of natural resources
Technological breakthroughs
Sudden changes in economic system; tax cuts
Higher output; lower price level

26. Exhibit 7 Effects of a beneficial supply shock on aggregate supply
LRAS
LRAS’
SRAS130
Given the AD curve, a beneficial supply shock that has a lasting effect, such as a breakthrough in technology, will permanently shift both the short-run aggregate supply curve and the long-run aggregate supply curve, or potential output. A beneficial supply shock lowers the price level and increases output, as reflected by the change in equilibrium from a to b.
Price
level
130
125
SRAS125
AD” a b
Real GDP
(trillions of dollars)
14.2
14.0
A temporary beneficial supply shock (an unusually favorable growing season), will shift the AS curves only temporarily. If the next growing season returns to normal, the AS curves will return to their original equilibrium position at a.

27. Shifts of the Aggregate Supply Curve
Adverse supply shocks
Decrease aggregate supply (SRAS, LRAS)
A drought
Overthrow of government
Terrorist attacks
Stagflation
Lower output
Higher price level

28. Exhibit 8 Effects of an adverse supply shock on aggregate supply LRAS”
SRAS135
Price
level
130
125
Given the AD curve, an adverse supply shock, such as an increased threat of terrorism, shifts the short-run and long-run aggregate supply curves to the left, increasing the price level and reducing real GDP, a movement called stagflation. This change is shown by the move in equilibrium from a to c.
SRAS130
AD” c a
Real GDP
(trillions of dollars)
14.0
13.8
If the shock is just temporary, the shift of the aggregate supply curves will be temporary.

29. Why is unemployment so high in Europe?
2007: 8-9%
Hysteresis
Natural rate of unemployment
Recent history of unemployment
Generous unemployment benefits

30. Why is unemployment so high in Europe?
Legislation: difficult to lay off workers
Mandatory severance pay
Reluctance to hire new workers
High minimum wages
High payroll taxes
Expanded lists of worker rights