1. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved ECON Designed by Amy McGuire, B-books, Ltd. McEachern 2010- 2011 11 CHAPTER Aggregate Supply Macro

2. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Labor and Aggregate Supply  Labor –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

3. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Labor and Aggregate Supply  Nominal wage –Money wage  Real wage –In constant dollars  Negotiation –Expected price level

4. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Natural Rate of Unemployment  Natural rate of unemployment –Unemployment rate when Potential output –No cyclical unemployment –Some frictional, structural, and seasonal unemployment –4-6%

5. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 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

6. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Short-Run Aggregate Supply Curve SRAS 130 Potential output Price level 140 120 130 Real GDP (trillions of dollars) 014.0 a 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. Exhibit 1

7. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Long-Run Adjustment When the Price Level Exceeds Expectations Expected price level=130, SRAS 130 If actual price level turns out as expected, the quantity supplied = potential output of $14 trillion. Given the AD curve, price level > expected; output exceeds potential (b); expansionary gap. In the long-run, price-level expectations and nominal wages will be revised upward. Costs will rise and the SRAS curve shifts leftward to SRAS 140. Eventually, the economy will move to long-run equilibrium (c), thus closing the expansionary gap. LO 2 Exhibit 2 Potential output Price level 140 130 135 AD SRAS 130 b Real GDP (trillions of dollars) 014.014.2 a SRAS 140 c LRAS

8. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Long-Run Adjustment When the Price Level Is Below Expectations Actual price level < expected (intersection of AD” with SRAS 130 ); short-run equilibrium: (d). Production below economy’s potential opens a contractionary gap. 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 SRAS 120 and the economy moves to long-run equilibrium at (e), with output increasing to the potential level of $14.0 trillion. LO 2 Exhibit 3 Potential output Price level 130 120 125 AD” SRAS 130 d Real GDP (trillions of dollars) 014.013.8 SRAS 120 e LRAS a

9. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 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

10. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Long-Run Aggregate Supply Curve 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. LO 2 Exhibit 4 Price level 140 120 130 AD” Real GDP (trillions of dollars) 014.0 Potential output LRAS AD AD’ b a c

11. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Wage Flexibility and Employment  Expansionary gap –Labor shortage –Higher nominal wage –Higher price level  Contractionary gap –Nominal wages = “sticky” downward –Slow to close

12. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Effect of a Gradual Increase in Resources on Aggregate Supply 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. LO 3 Exhibit 5 Price level LRASLRAS’ Real GDP (trillions of dollars) 0 14.5 14.0

13. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 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 LO 3

14. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Effects of a Beneficial Supply Shock on Aggregate Supply 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. 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. LO 3 Exhibit 6 LRASLRAS’ Real GDP (trillions of dollars) 0 14.2 14.0 Price level 130 125 AD” SRAS 130 SRAS 125 b a

15. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 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 LO 3

16. Chapter 11Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Effects of an Adverse Supply Shock on Aggregate Supply 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. If the shock is just temporary, the shift of the aggregate supply curves will be temporary. LO 3 Exhibit 7 LRASLRAS” Real GDP (trillions of dollars) 0 14.0 13.8 Price level 130 125 AD” SRAS 130 SRAS 135 c a