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

Pri

ce L

evel

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(Wage0)AS(Wage fixed)CauseCause

EffectEffect

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/Productivity

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

Direct

Factors that affect Supply

Factors that shift Aggregate Supply

An increase in wages shifts AS left

Pri

ce L

evel

Real GDP supplied

Profit = Price - Costsame

AS(Wage0)

AS(Wage1)

P0

Y1 Y0

Firms produce LESS when wages increase

Improvements in technology, increase in Stock of Capital &

labor forceP

rice L

evel

Real GDP supplied

AS0

AS1

P0

Y1Y0

Firms produce MORE with better technology, larger labor

force and stock of capital

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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)

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Increase Production

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Po

GDPo

Aggregate Supply

Aggregate Demand

P1

GDP1

Supply larger than Demand:

Inventories rise, Firms cut

prices

Produce More

Demand SupplyGDPo 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%.

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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.

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Po

Goods and Services Produced

Goods and Services PurchasedAggregate 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

120

130

140

3000 3200 3400

1. 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

Increase

Improvement

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Po

Goods and Services Purchased

AD = C + I + G + NXGDPo

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

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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

GDPo GDP1

Supply DemandGrowth

Bad Inflation

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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

Supply DemandRecessionUnemploymen

t increases

GDPoGDP1

Good Deflation

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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

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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

dropDeflation

Unemployment increases

Buy Less

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Price Level

Real GDP

ASo

AD1ADo

Price Level

Real GDP

ASo AS1

ADo

Price Level

Real GDP

ASoAS1

ADo

Price Level

Real GDP

ASo

AD1ADo

Recession and deflation

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Recession and inflation

Growth and deflationGrowth 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

AB

C

D

EWhich graph best describes the effect of the following eventsF

E2

E1S2

S1

D1

D2

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 ADS2

S1

D1

D2

AD shifts more than AS

S2

S1

D1

D2

AS shifts by the same amount as AD

P

GDP

E1

E2

E1 E2