Download LECTURE 5 Aggregate Supply

ABSE 204
Aggregate Supply
Aggregate supply (AS) is the willingness and ability of firms to produce GDP at
every price level, ceteris paribus.
The aggregate supply curve shows the combinations of the general price level and
total output.
1. The aggregate supply in the short run
There are two aggregate supply curves: one for the short-run and one for the longrun. From the macroeconomic point of view, the short run is a period, during which, the
changes in the prices final goods and services and in the prices of production factors are
not synchronized.
We will derive the short run aggregate supply curve with the help of the production
possibility frontier model.
If the economy is in point U this means that many production factors are not used
in production. There is high unemployment and excess capacity. The AD is very low
and below the potential GDP. The firms would increase production at the current
price level - they do not need to be motivated by a price increase. If only the firms
can find buyers, they would hire more workers and increase output at the same price
level. The economy moves to point т. V. However, due to the law of diminishing
returns marginal costs start rising. The firms would increase production if only their
buyers are willing to compensate them for the cost increase. Since average costs grow
more slowly than МС (short run and fixed cost), the increase in production is faster
than the increase in the price level, i.е. production will increase faster than the price
level until it gets to point W. At point W the economy operates at full capacity. Any
further increase in production will be accompanied by a faster increase in cost. The
firms would increase production if only their buyers are willing to compensate them
for the cost increase – the price level will rise faster than output – the economy will
move from point W to point Z.
AS
Physical PPF
CPI
Z
Institutional PPF
W
Z
W
V
U
U
V
Real GDP
Fig. 1. The Production possibility frontier and the short run aggregate supply
curve
Thus, the short run AS curve has five segments:
1. Horizontal - the elasticity (E) is not determined Е = ∞ - from U to V – the firms
are willing to increase production at the current price level; the economy operates
at excess capacity
2. Shallow Е > from V to W – output rises faster than the price level
3. E = 1 – point W – the economy operates at full capacity on the Institutional PPF
and produces potential GDP; the rate of unemployment is equal to the natural rate
4. Steep E < 1 – from W to Z – the economy operates at overcapacity – prices
increase faster than output
5. Vertical Е = 0 – from Z – firms cannot increase output whatever the price level is.
The economic activity is on its physical PPF
6. Slope of the AS curve in the short run – determined by the law of diminishing
returns and the price adjustment to cost increase
Factors, determining the shifts in the short run aggregate supply curve
1. Cost of production:
 Labor cost – depends on education, traditions (attitude to work and leisure),
labor supply, competitiveness of the market structure, expectations,
productivity
 Capital cost – depends on the savings and investment structure, raw material
supplies, technological changes, competitiveness of capital markets
2. Government policies – regulations, taxation, social programs
3. Foreign sector – barriers to international trade, structure of the balance of
payments
If labor cost in the economy increase, the cost of production increases, the short
run aggregate supply falls and the short run aggregate supply curve shifts to the
left.
If the prices of raw materials (the energy resources, for instance) fall, the short
run aggregate supply curve rises and the short run aggregate supply curve shifts to
the right.
The competitiveness of the market structure is an important factor, affecting the
short run aggregate supply. If the production of important resources in the
economy is dominated by powerful monopolies, they might raise the prices of
their goods and services, which would shift the short run aggregate supply curve
to the left. This is the case with the increase in the price of electricity, or gasoline.
The reduction in the tax rates on businesses would reduce the cost of production
and shift the short run aggregate supply curve to the right.
The changes in the international environment affect the short run aggregate
supply as well. If the tariffs on imported raw materials are reduced, the short run
aggregate supply rises and the short run AS curve shifts to the right. If the
domestic currency appreciates, the imports of raw materials become more
expensive and the short run aggregate supply falls.
2. The aggregate supply in the long run
From macroeconomic point of view, the Long run is a period when the increases
in the overall price level and in the prices of production factors are entirely synchronized.
In the long run, the increase in the prices of final goods and services does not
motivate the firms to increase output, since their cost would increase at the same rate.
Therefore, the long run aggregate supply curve is vertical – fig. 2.
Price level
AD
AS
Real GDP
Fig. 2. The long run Aggregate supply curve
The location of the long run aggregate supply curve is determined by the
potential GDP.
Factors, determining AS in the long run:
 Labor resources – quantity and quality, productivity, education, traditions,
motivation, demographic factors
 Capital resources – quantity and quality, rate of capital accumulation
 Technological changes
 Institutional changes
The increase in the quantity and quality of resources in the economy raise the
production potential in the economy and shift the long run aggregate supply curve
to the right.
The information revolution of the late XXth century has raised the potential of
the economy and has shifted the long run AS curve to the right.
Institutional changes improving the business environment shift the
institutional production possibility frontier and the long run AS curve to the right.