Aggregate supply module 18

AGGREGATE SUPPLY:

INTRODUCTION AND

DETERMINANTS

MODULE 18

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AGGREGATE SUPPLY

• The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy.

• There is a distinction between the short-run and the long-run aggregate supply curves.

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THE SHORT-RUN AGGREGATE SUPPLY CURVE

• There is a positive relationship, in the short run, between the aggregate price level and the quantity of aggregate output supplied.

• Other things equal, a rise in the aggregate price level is associated with a rise in the quantity of aggregate output supplied; a fall in the aggregate price level is associated with a fall in the quantity of aggregate output supplied.

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UPWARD SLOPING SHORT-RUN AGGREGATE SUPPLY CURVE

• Producers will produce more goods and services the more profitable it is for them .

• Profit per unit of output= Price per unit of output – Production cost per unit of output

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WHY IS THE SHORT-RUN AGGREGATE SUPPLY CURVE

UPWARD SLOPING?• Is the price the producer receives

for a unit of output greater or less than the cost of producing that unit of output?

• Remember that many of the costs producers face are fixed per unit of output and can’t be changed for a certain period of time.

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“STICKY” WAGES

• Wages are typically an inflexible production cost because nominal wages are determined by contracts that were signed some time ago.

• Companies are also reluctant to change wages in response to economic conditions.

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“STICKY” WAGES

• Producers won’t lower wages in times of an economic downturn (unless it is particularly long and severe) for fear of creating worker resentment.

• Producers won’t raise wages during good economic times (until they are at risk of losing employees to competitors) as they won’t want to encourage them to routinely demand higher wages.

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“STICKY” WAGES• Therefore, the economy is

characterized by sticky wages: nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages.

• Sticky wages cannot be sticky forever, as ultimately, formal contracts and informal agreements will be renegotiated to take the economic circumstances into account.

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SHORT RUN TO LONG RUN

• How long it takes for nominal wages to become flexible is the integral component that differences the short run from the long run.

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SUPPLY TO AGGREGATE SUPPLY

• Remember from microeconomics that perfectly competitive firms will supply more of a good when the price is higher, increasing the output, to increase profit.

• Conversely, when the price falls, the profit falls as well, so perfectly competitive firms will decrease output in response to a falling price.

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SUPPLY TO AGGREGATE SUPPLY• Now imagine an imperfectly

competitive producer that sets its own price: if there is a rise in demand for his product, he will be able to sell more at any given price, so he will probably choose to increase his prices as well as his output, to increase profit.

• An industry’s “pricing power” means that when demand is strong, firms with pricing power are able to raise prices-and they do.

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SUPPLY TO AGGREGATE SUPPLY

• Conversely, when there is a fall in demand, firms will try to limit the fall in their sales by cutting prices.

• Therefore, the response of firms in both perfectly competitive industries and imperfectly competitive industries lead to an upward-sloping relationship between aggregate output and the aggregate price level.

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SHORT RUN AGGREGATE SUPPLY CURVE

• The short-run aggregate supply curve shows relationship between the aggregate price level and the quantity of aggregate output supplied that exists during the short run, which is the time period when many production costs (particularly nominal wages), can be taken as fixed.

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• The positive relationship between the aggregate price level and aggregate output in the short run gives the short-run aggregate supply curve its upward slope.

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SHIFTS OF THE SHORT RUN AGGREGATE SUPPLY CURVE

• Movements along the short-run aggregate supply curve (SRAS) are due to changes in the aggregate price level.

• However, there can also be shifts of the SRAS curve.

• A decrease in SRSA means a shift leftward of the curve and an increase in SRAS means a shift rightward of the curve.

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• Aggregate supply increases when producers increase the quantity of aggregate output they are willing to supply at any given aggregate price level.

• Anything that changes the production costs will change the amount of profit the producer earns, and will shift the SRAS curve.

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• There are three important factors that affect producer’s profit per unit and shifts in the SRAS curve:

1. Changes in commodity prices2. Changes in nominal wages3. Changes in productivity

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CHANGES IN COMMODITY PRICES

• A commodity is a standardized input bought and sold in bulk quantities. They are not a final good, so their prices are not included in the calculation of the aggregate price level.

• However, commodities represent a significant cost of production to most suppliers, so their prices have large impacts on production costs.

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CHANGES IN COMMODITY PRICES• An increase in the price of a

commodity raises production costs across the economy and reduces the quantity of aggregate output supplied at any price level, shifting the SRAS curve to the left.

• Conversely, a decrease in commodity prices reduces the production costs, leading to an increase in the quantity supplied at any aggregate price level and a rightward shift of the SRAS curve.

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CHANGES IN NOMINAL WAGES

• Dollar wages are fixed because they are set by contracts or informal agreements made in the past.

• However, once enough time has passed for the contracts and agreements to be renegotiated, these nominal wages can change.

• This will increase production costs and shift the SRAS curve to the left.

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• Conversely, when there is a fall in the nominal wages, this will reduce production costs and shift the SRAS curve to the right.

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• An increase in the price of a commodity will have a “knock on” effect which magnifies the leftward shift of the SRAS curve when there are cost-of-living allowances built into the wage contracts.

• The increase in commodity prices will lead to an increase in overall consumer prices, which then causes a rise in nominal wages.

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CHANGES IN PRODUCTIVITY

• An increase in productivity means that a worker can produce more units of output with the same quantity of inputs.

• When productivity increases, producer costs fall and profits rise.

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• Therefore, a rise in productivity increases the producer’s profits and shifts the SRAS curve to the right.

• Conversely, a fall in productivity reduces the number of units of output a worker can produce with the same quantity of inputs. The cost per unit of output rises, profit falls, and quantity supplied falls. This shifts the SRAS curve to the left.

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FACTORS THAT SHIFT THE SHORT-RUN AGGREGATE SUPPLY CURVE

CHANGES IN COMMODITY

PRICES

If commodity prices fall… SRAS increases

If commodity prices rise… SRAS decreases


If nominal wages fall… SRAS increases

If nominal wages rise… SRAS decreases


If workers become more productive…

SRAS increases

If workers become less productive…

SRAS decreases

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THE LONG-RUN AGGREGATE SUPPLY CURVE• In the long run, nominal wages are

flexible, not sticky. • This wage flexibility alters the long-

run relationship between the aggregate price level and aggregate supply.

• In the long run, the aggregate price level has no effect on the quantity of aggregate output supplied.

• Therefore the long run is defined as the period of time in which all prices are fully flexible.

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THE LONG-RUN AGGREGATE SUPPLY CURVE

• In the long run, inflation or deflation has the same effect as changing all the prices by the same proportion.

• As a result, changes in the aggregate price level don’t change the quantity of aggregate output supplied in the long run.

• Changes in the aggregate price level, in the long run, will be accompanied by equal proportional changes in all input prices, including nominal wages.

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• The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible.

• The LRAS curve is vertical because changes in the aggregate price level have no effect on aggregate output in the long run.

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• The position of the LRAS curve on the horizontal axis is an important benchmark for output.

• The LRAS curve is located at the point of potential output, the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible.

• This point defines the trend around which actual output fluctuates from year to year.

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LONG-RUN AGGREGATE SUPPLY

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SHIFTS IN THE LRAS CURVE

• Rightward shifts in the LRAS curve are related to long-run economic growth:

1. Increase in the quantity of resources, including land, labor, capital, and entrepreneurship

2. Increases in the quality of resources

3. Technological progress

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SHIFTS IN THE LRAS CURVE

• Long-run economic growth is growth in the economy’s potential output.

• The LRAS curve shifts to the right over time as economy experiences long-run growth.

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FROM THE SHORT RUN TO THE LONG RUN

• The economy normally produces more or less than potential output.

• So the economy is normally on its SRAS curve but not on its LRAS curve.

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FROM THE SHORT RUN TO THE LONG RUN• The economy is always in one of two

states with respect to the short-run and long-run aggregate supply curves:

1. It can be on both curves simultaneously, by being on the point where both curves intersect (when both actual and potential output coincide)

2. It can be on the SRAS curve but not on the LRAS curve (when actual aggregate output and potential output do not coincide).

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FROM THE SHORT RUN TO THE LONG RUN

• If the economy is on the short-run but not the long-run aggregate supply curve, the SRAS curve will shift over time until the economy is at a point where both curves cross-a point where actual aggregate output is equal to potential output.

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LONG RUN EQUILIBRIUM

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EQUILIBRIUM IN THE LONG RUN

Read through the Figure 18.5 on page 187 to see how the process of adjusting from a point higher than or lower than actual output will tend to shift the SRAS curve back to intersect with the LRAS curve at potential output.

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RECESSIONARY GAP

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INFLATIONARY GAP

Education

Aggregate supply module 18