1. 1 Aggregate Supply CHAPTER 26 © 2003 South-Western/Thomson Learning

2. 2 Aggregate Supply in Short Run Aggregate supply is the relationship between the price level in the economy and the aggregate output firms are willing and able to supply, with other things constant Assumed constant along a given aggregate supply curve are Resource prices State of technology Set of formal and informal institutions that structure production incentives

3. 3 Labor and Aggregate Supply Labor is the most important resource, accounting for about 70% of production costs The supply of labor in an economy depends on The size and abilities of the adult population, and Household preferences for work versus leisure

4. 4 Labor and Aggregate Supply Along a given labor supply curve, the quantity of labor depends on the wage rate  the higher the wage, other things constant, the more people are willing and able to work Things get a bit more complicated when we recognize that the purchasing power of any given nominal wage depends on the economy’s price level

5. 5 Labor and Aggregate Supply The higher the price level, the less any given money wage will purchase and the lower the price level, the more any given money wage will purchase Because the price level matters, we must distinguish between the nominal wage and the real wage Nominal wage measures the wage in current dollars Real wage measures the wage in constant dollars  dollars measured by the goods and services they will buy

6. 6 Real and Nominal Wages Workers and employers care more about the real wage than about the nominal wage The problem is that nobody knows for sure what price level will prevail during the life of the wage agreement  labor contracts must be negotiated in terms of nominal wages Resource prices that are set by long- term contracts remain in force for extended periods

7. 7 Real and Nominal Wages Thus, by implication, all resource suppliers, including labor, must reach agreement based on the expected price level Wage agreements may be either explicit or implicit Explicit agreements would be those based on a labor contract Implicit agreements would be those based on labor market practices

8. 8 Potential Output Firms and resource suppliers expect a certain price level to prevail in the economy during the year This price level can be regarded as resulting from the consensus view of inflation for the upcoming year Based on these consensus expectations, firms and resources suppliers reach agreement on resource prices, such as wages

9. 9 Potential Output If these price-level expectations are realized, the agreed-upon nominal wage translates into the expected real wage When the actual price level turns out as expected, the resulting level of output is referred to as the economy’s potential output Potential output is the amount produced when there are no surprises associated with the price level Therefore, workers are supplying the quantity of labor they want to and firms are hiring the quantity of labor they want to

10. 10 Potential Output Potential output can be thought of as the economy’s maximum sustainable output level, given the Supply of resources State of technology Formal and informal production incentives Often referred to by other terms Natural rate of output Full-employment rate of output

11. 11 Natural Rate of Unemployment Natural rate of unemployment The unemployment rate that occurs when the economy is producing its potential GDP The rate that prevails when cyclical unemployment is zero The number of job openings is equal to the number unemployed for frictional, structural, and seasonal reasons Estimates of the natural rate range from about 4 to 6% of the labor force Summary: when the actual price level turns out as anticipated, the expectations of both workers and firms are fulfilled  economy produces its potential

12. 12 Actual Price Higher than Expected What if the economy’s price level turns out to be higher than expected? What happens in the short run to aggregate output supplied? The short run is a period during which many resource prices remain fixed by contract

13. 13 Actual Price Higher than Expected Since the prices of many resources are fixed for the duration of the contract, firms welcome a price level is higher than expected Their selling price (thus revenue) of their products, on average, are higher than expected, while the costs of at least some of the resources remain constant  firms have an incentive in the short run to expand production beyond the economy’s potential level

14. 14 Actual Price Higher than Expected While it may appear contradictory to talk about producing beyond the economy’s potential, remember that potential output does not mean zero unemployment Rather, it means that the actual unemployment rate equals the natural rate of unemployment  approximately 96% of the labor force working

15. 15 Actual Price Higher than Expected That is, even in an economy producing its potential output, there is some unemployed labor and unused production capacity Potential GDP can be thought of as the economy’s normal capacity Firms and workers are able, in the short run, to push output beyond the economy’s potential

16. 16 Why Costs Rise As output expands above potential GDP, the cost of producing this additional output increases Additional workers are harder to find Some workers may not be properly prepared The prices of those resources purchased in markets where prices are flexible will increase reflecting their increased scarcity Firms use their capital resources more intensively

17. 17 Why Costs Rise However, because the prices of some resources are fixed by contracts, the price level rises faster than the per-unit production cost  firms find it profitable to increase the quantity supplied When the actual price level exceeds the expected price level, the real value of an agreed-upon nominal wage declines

18. 18 Why Costs Rise Why might workers be willing to increase the quantity of labor they supply when the price level is higher than expected? One possible reason is that the labor agreement might require workers to offer their labor at the agreed upon nominal wage

19. 19 Summary If the price level is higher than expected, firms have a profit incentive to increase the quantity of goods and services supplied At higher rates of output, however, the per-unit cost of additional output increases Firms will expand output as long as the revenue from additional production exceeds the cost of the production

20. 20 Actual Price Lower than Expected What happens if the price level turns out to be lower than expected? Production is less attractive to firms because the prices they receive for their output are on average lower than they expected However, many of their production costs, such as the nominal wage, do not fall  production is less profitable than expected  firms reduce their quantity supplied  the economy’s output is below its potential

21. 21 Actual Price Lower than Expected As a result, some workers are laid off and capital resources go unused In this case, some costs decline when output falls below the economy’s potential As output falls, some resources become unemployed  the prices of resources decline in markets where the price is flexible and firms can become more selective about which resources to retain

22. 22 Summary If the price level is higher than expected Firms increase the quantity supplied beyond the economy’s potential The per-unit cost of additional production increases If the price level is lower than expected Firms reduce output below the economy’s potential output Prices fall more than costs The combination of these two changes implies that there is a direct relationship in the short run between the actual price level and real GDP supplied

23. 23 Short-Run Aggregate Supply Curve What what have just described can be used to trace out the short-run aggregate supply curve – SRAS SRAS shows the relationship between the actual price level and real GDP supplied, other things constant The short run is the period during which some resource prices are fixed by either explicit or implicit agreement

24. 24 Exhibit 1:Short-Run Aggregate Supply Curve P r i c e l e v e l 140 130 120 Potential output 0 10.0 Real GDP (trillions of dollars) SRAS 130 a The expected price level is 130; the SRAS is based on that expected price level. If the price level turns out to be 130 as expected, producers supply the economy’s potential level of output, $10.0 trillion.

25. 25 Short-Run Aggregate Supply Curve If the economy produces its potential output, unemployment is at the natural rate Thus, there is not tendency to move away from point a even if workers and firms have a chance to renegotiate their contracts

26. 26 Exhibit 1: Short-Run Aggregate Supply Curve P r i c e l e v e l 140 130 120 Potential output 0 10.0 Real GDP (trillions of dollars) SRAS 130 a Levels of output that fall short of the economy’s potential are shaded red and levels of output that exceed the economy’s potential are shaded blue. The slope of the short-run aggregate supply curve depends on how sharply the cost of additional production rises as aggregate output expands. If, in the short run, increases in per unit costs are modest as output expands, the supply curve will be relatively flat. But if per unit costs increase sharply as output expands, the supply curve will be relatively sharp. The short-run aggregate supply becomes steeper as output increases because resources become more costly as output increases

27. 27 From the Short Run to the Long Run Here we begin with a short-run equilibrium that is higher than expected to see what happens in the long run The long run is long enough so that firms and resource suppliers are able to renegotiate all agreements based on knowledge of the actual price level  there are no surprises about the price level

28. 28 Exhibit 2: Expansionary Gap a output 130 Potential 0 10.0 Real GDP (trillions of dollars) SRAS 130 Price level 140 Expansionary gap 135 AD b 10.2 The initial short run supply curve for the expected price level of 130 is SRAS 130 Given this short-run aggregate supply curve, the equilibrium price level and real GDP depend on the aggregate demand curve. The actual price level will equal the expected price level only if the aggregate demand curve intersects the aggregate supply curve at point a. The amount by which short-run equilibrium output exceeds the economy’s potential is often referred to as the expansionary gap, which in our example is $0.2 trillion. What if aggregate demand turns out to be greater than expected, as shown by curve AD. Point b is the short-run equilibrium, reflecting a price level of 135 and a real GDP of $10.2 trillion  the actual price level is higher than expected and the level of output exceeds the economy’s potential.

29. 29 Exhibit 2: Expansionary Gap a output 130 Potential 0 10.0 Real GDP (trillions of dollars) SRAS 130 Price level 140 SRAS 140 Expansionary gap c 135 AD b 10.2 What happens in the long run? The long run is a period during which firms and resource suppliers have the time to renegotiate their agreements: nominal wages increase, firms’ production costs increase, and the short-run aggregate supply curve shifts leftward to SRAS 140 at point c, where the actual price level equals the expected price level. Actual output can exceed the economy’s potential in the short run, but not in the long run. When real GDP exceeds potential output, the actual unemployment rate is below its natural rate. Further, because the price level prevailing in the short run exceeds the expected price level, the real wage is lower than expected.

30. 30 Long-Run Equilibrium Consider all the equalities that hold in long-term equilibrium The actual price level equals the expected price level The quantity supplied in the short run equals potential output, which also equals the quantity supplied in the long run The quantity supplied equals the quantity demanded

31. 31 Long-Run Equilibrium The long-run equilibrium attained at point c is no different in real terms from what had been expected at point a At both points Firms are willing and able to supply the economy’s potential level of output The same amounts of labor and other resources are employed The real wage and real return to other resources are the same even though nominal wages and payments are higher

32. 32 Exhibit 3: Contractionary Gap Again, begin with an expected price level of 130. Suppose the aggregate demand curve intersects the short-run aggregate supply curve to the left of potential output (point d): production is less than the economy’s potential. The amount by which actual output falls short of potential GDP is called the contractionary gap, which in our case is $0.2 trillion. Unemployment exceeds the natural rate. The lower than expected price level translates into a higher real wage in the short run. 130 Potential output 0 10.0 SRAS 130 Price level a Contractionary gap 125 9.8 d AD 120 e

33. 33 Exhibit 3: Contractionary Gap What happens in the long run? Employers are no longer willing to pay as high a nominal wage and with the unemployment rate higher than the natural rate, more workers are competing for jobs, putting downward pressure on the nominal wage - costs of production decline 130 Potential output 0 10.0 SRAS 130 Price level a Contractionary gap 125 9.8 d AD 120 SRAS 120 e The economy will reach long-run equilibrium at point e. The SRAS curve shifts rightward until it intersects the aggregate demand curve, where the economy produces its potential output at SRAS 120.

34. 34 Contractionary Gap The key to closing a contractionary gap is the flexibility of wages and prices If wages and prices are not very flexible, they will not adjust very quickly to a contractionary gap  shifts in the short-run aggregate supply curve may occur slowly  the economy can be stuck at an output and employment level below its potential

35. 35 Long-Run Aggregate Supply The long-run aggregate supply curve, LRAS, depends on the supply of resources in the economy level of technology production incentives provided by the formal and informal institutions of the economic system As long as wages and prices are flexible, the economy’s potential GDP is consistent with any price level

36. 36 Exhibit 4: Long-Run Aggregate Supply Curve 130 Potential output LRAS 0 Real GDP (trillions of dollars) a AD 10.0 c AD'' 120 b AD' 140 The initial price level of 130 is determined by the intersection of AD with the long-run aggregate supply curve. If the aggregate demand curve shifts out to AD´, then in the long run the equilibrium price level will increase to 140, where the same level of economy’s potential GDP is realized. A decline in aggregate demand from AD to AD ´´ will, in the long run, lead only to a fall in the price level with no change in output. Price level

37. 37 Wage Flexibility and Employment What evidence is there that a vertical line drawn at the economy’s potential GDP can depict the long-run aggregate supply curve? Except during the Great Depression, unemployment over the last century, while varying from year to year, has typically returned to what would be viewed as a natural rate of unemployment

38. 38 Wage Flexibility and Employment An expansionary gap creates a labor shortage that eventually results in a higher nominal wage and a higher price level A contractionary gap does not necessarily generate enough downward pressure to lower the nominal wage, e.g., that is, nominal wages are slow to adjust to high unemployment  they tend to be sticky in the downward direction

39. 39 Wage Flexibility and Employment Since nominal wages fall slowly, if at all, the natural supply-side adjustment needed to close a contractionary gap may take so long as to seem ineffective However, an actual decline in the nominal wage is not necessary to close a contractionary gap All that is needed is a fall in the real wage The real wage will fall as long as the price level increases more than the nominal wage

40. 40 Changes in Aggregate Supply We now consider factors other than changes in the expected price level that may affect aggregate supply In doing this, we must distinguish between long-term trends in aggregate supply, and supply shocks, which are unexpected events that affect aggregate supply, often only temporary

41. 41 Increases in Aggregate Supply The economy’s potential output is based on the willingness and ability of households to supply resources to firms which can be caused by a change in the size, composition, or quality of the labor force in household preferences for labor versus leisure level of technology institutional underpinnings of the economic system

42. 42 Exhibit 6: Change in the Supply of Resources P r i c e l e v e l 10.510.00 Real GDP (trillions of dollars) LRAS'LRAS A gradual increase in the supply of resources increases the potential level of real GDP  the long run aggregate supply curve shifts from LRAS to LRAS'

43. 43 Supply Shocks Supply shocks are unexpected events that change aggregate supply, sometimes only temporarily Beneficial supply shocks increase aggregate demand; examples include Abundant harvests that increase the supply of food Discoveries of natural resources Technological breakthroughs that allow firms to combine resources more efficiently Sudden changes in the economic system that promote more production

44. 44 Exhibit 7: Beneficial Supply Shock LRAS 10.00 Real GDP (trillions of dollars) 130 AD a SRAS 130 10.2 LRAS' 125 SRAS 125 b Here, the beneficial supply shock is assumed to be a technological breakthrough, which shifts the SRAS from SRAS 130 to SRAS 125 and the long-run aggregate supply curve from LRAS to LRAS´. Thus, for a given aggregate demand curve, a beneficial supply shock leads to an increase in output and a decrease in the price level. Price level

45. 45 Decreases in Aggregate Supply Adverse supply shocks are sudden, unexpected events that reduce aggregate supply, again sometimes, only temporarily Drought could reduce the supply of a variety of resources Government instability Terrorist attacks

46. 46 Exhibit 8: Adverse Supply Shock P r i c e l e v e l LRAS 10.00 Real GDP (trillions of dollars) 130 SRAS 130 AD a 135 LRAS'' SRAS 135 c 9.8 The adverse supply is shown as the leftward shift of both the short and long-run aggregate supply curves with the result that the price level increases and the level of output declines  stagflation as equilibrium moves from point a to point c