Download Activity 24

UNIT
3 Macroeconomics
LESSON 4
Aggregate Supply
Introduction and Description
Aggregate supply is the quantity of output that firms
are willing and able to produce for the economy. In
the long run, the level of output depends on the capital stock, the labor force and the level of technology.
In the short run, the level of output depends on the
amount of labor employed with a given level of capital and technology. The students should understand
the aggregate supply curve and its determinants
because the adjustment process in the economy to
changes in aggregate demand or aggregate supply
depends on understanding the determinants of
aggregate supply. The aggregate supply curve is
derived in the Appendix to this lesson.
Activity 24 provides practice with the aggregate
supply curve and understanding movements along
and shifts in the aggregate supply curve.
Objectives
1. Define aggregate supply.
2. Explain why the aggregate supply curve is
upward sloping.
3. Describe the factors that affect aggregate supply.
4. Explain what factors will shift the aggregate
supply curve.
Time Required
Two class periods or 90 minutes
Materials
1. Activity 24
2. Visuals 3.9 and 3.10
Procedure
1. Tell the students that this lesson develops the
other side of the macroeconomy: aggregate supply. Define aggregate supply: Aggregate supply is
the total supply of all goods and services in the
economy. The aggregate supply curve shows the
468
relationship between total quantity of output
supplied by all firms and the overall price level.
Point out that the aggregate supply curve is not
the sum of individual firm supply curves. In
microeconomics, a firm’s supply curve is
derived by changing price and holding all other
variables constant, including costs. However, if
there is an increase in the overall price level, it is
unrealistic to assume that costs are constant for
individual firms. The aggregate supply curve is
the relationship between production and the
price level; it is sometimes called a price-output
adjustment curve.
2. Explain that aggregate supply, or real gross
domestic product (GDP), depends on the quantity of labor, the quantity of capital and the level
of technology. In the short run, the capital and
level of technology are fixed, and only the quantity of labor changes. A short-run aggregate
supply (SRAS) curve assumes the money wage,
resource prices and potential GDP are constant.
With the money wage, resource prices and
potential GDP constant, as the overall price
level rises, firms will produce more output.
The short-run aggregate supply curve can be
shaped as a horizontal line, a vertical line or a
positively sloped line. We usually draw the
aggregate supply curve as positively sloped, as
seen in Visual 3.9.
3. Still using Visual 3.9, explain that the long-run
aggregate supply (LRAS) curve is vertical at full
employment, or potential GDP. If there is an
increase in the overall price level that is matched
by equal percentage increases in the moneywage rate and other resource prices, the economy will remain at potential GDP. Following
adjustments, the SRAS and AD curves intersect
along the LRAS curve.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
4. Explain that the SRAS will change (a shift in
the curve) if the potential GDP changes, or if
money wages or other resource prices change.
Changes in potential GDP can occur if there is
a change in the full-employment quantity of
labor, a change in the quantity of capital or a
technological advance. Visual 3.10 summarizes
the effects for an increase in the long-run aggregate supply. We can also use Visual 3.10 to show
a decrease in money-wage rates. A decrease in
money-wage rates shifts the SRAS but not the
LRAS because a change in the money-wage rate
is matched by an equal change in the price level
in the long run.
A graphical derivation and discussion of the
aggregate supply curve is provided in the
Appendix to this lesson. This discussion is for
LESSON 4
the benefit of the teacher and may be provided
to the students at the teacher’s discretion.
5. For the second day, propose various scenarios
and have the students tell you in which direction the SRAS curve moves and why it moves in
that direction. Here are some examples of shifts
in SRAS:
■
■
■
An increase in labor productivity will shift
SRAS to the right.
An increase in the average wage rate will shift
SRAS to the left.
An increase in technology will shift SRAS to
the right.
6. Have the students complete Activity 24. Review
the answers with the students.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
469
UNIT
3 Macroeconomics
LESSON 4
Appendix to Lesson 4
In this appendix we show the derivation of the short-run aggregate supply curve, the long-run aggregate supply curve and the use of these models to show economic growth.
The Short-Run Aggregate Supply Curve
The aggregate supply curve represents the relationship between the price level and the level of
production. We can look at the microfoundations of the aggregate supply curve by looking at Appendix Figure 4.1. In Appendix Figure 4.1, the top left graph is the short-run production function; the
bottom left graph is the labor market. The top right graph is a 45o line; this graph is used only to
transfer real GDP from the vertical axis to the horizontal axis. The bottom right graph is the shortrun aggregate supply curve.
Appendix Figure 4.1
Deriving the SRAS Curve
F(K, L, T)
Y
REAL GDP
REAL GDP
Y1
45˚
QUANTITY OF LABOR
REAL GDP
W/P
W/P1
LD
L
L1
QUANTITY OF LABOR
PRICE LEVEL
REAL WAGE
SRAS
P1
P
Y Y1
REAL GDP
This appendix was written by Rae Jean Goodman, U.S. Naval Academy, Annapolis, Md., and Charles Orvis, Rhodes College,
Memphis, Tenn.
470
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
LESSON 4
Looking at Appendix Figure 4.1, we have the short-run production function, which is a function of
the amount of labor input (L), capital (K) and technology (T). Capital and technology are fixed in the
short run. From the production function, assuming a perfectly competitive labor market, we can derive
the marginal product of labor, which is the slope of the production function (which equals the change
in output / change in labor = ∆Y / ∆L) and is the demand curve for labor. If the real wage is W / P, firms
will hire L amount of labor and produce Y real GDP. We then have one point on the SRAS: Y and P.
If the price level increases to P1, the real wage falls to W/P1; firms will hire L1 quantity of labor and produce Y1: real GDP. This gives us a second point on the SRAS curve: Y1 and P1. Thus, the short-run aggregate supply curve SRAS is determined by the nominal wage, W, and the given technology and capital stock.
Changes in the nominal wage (or other resource prices), in the capital stock or in technology will
shift the short-run aggregate supply curve. If we look at Appendix Figure 4.2, we can see the effects of
a change in the nominal wage. We show the derivation of the first SRAS curve. Now if nominal wages
rise to W1 such that W1 / P1 = W / P, we trace out a point on a new SRAS curve; the point involves a
nominal wage (W1), a price level (P1,) and real output of Y. This shows that with an increase in the
nominal wage, the short-run aggregate supply curve shifts leftward to SRAS1.
Appendix Figure 4.2
New SRAS with Increase in Nominal Wage
E1 F(K, L, T)
Y
E
REAL GDP
REAL GDP
Y1
45˚
W1/P1
= W/P
W/P1
REAL GDP
E, E2
E1
LD
PRICE LEVEL
REAL WAGE
QUANTITY OF LABOR
E2
P1
P
E
SRAS1
L
L1
QUANTITY OF LABOR
E1
SRAS
Y Y1
REAL GDP
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
471
UNIT
3 Macroeconomics
LESSON 4
We can examine other changes such as a change in technology or a change in the capital stock in
the same manner. The difference is that changes in capital or technology will cause a shift in the production function and thus will cause the SRAS and the LRAS curves to shift. This is discussed later in
this appendix.
The Long-Run Aggregate Supply Curve
There can be short-run changes in the aggregate demand curve, which will increase or decrease output along a fixed short-run aggregate supply curve (SRAS) without affecting the wage rate. The reasons that wages are not affected in the short run include explicit or implicit labor contracts, workers
do not recognize that the change in the price level affects their real wage, the efficiency-wage model or
imperfect competition.
Using Appendix Figure 4.3, we add a labor supply curve and an aggregate demand curve (AD). The
labor supply curve intersects the labor demand curve at the real wage, W / P; and the AD curve intersects the SRAS curve at the corresponding level of output, Y*. Equilibrium is labeled E.
Appendix Figure 4.3
Long-Run Aggregate Supply Curve
F(K, L, T)
Y
REAL GDP
REAL GDP
Y1
45˚
QUANTITY OF LABOR
REAL GDP
W1/P2
= W/P
W/P1
LRAS
SRAS1
SRAS
E2
E
PRICE LEVEL
REAL WAGE
LS
E2
E1
P2
P1
P
E1
E
AD
LD
L2 L
L1
QUANTITY OF LABOR
472
AD1
Y* Y1
REAL GDP
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
LESSON 4
Now assume there is an increase in AD to AD1. AD may increase because of an increase in the
money supply by the Federal Reserve or an increase in any one of the components of aggregate
demand: consumption, investment, government spending or net exports. The increase in AD will
cause both real GDP and the price level to increase to Y1 and P1, respectively. The increase in P will
reduce the real wage to W / P1 and move the labor market to a shortage position on the labor demand
curve but off the labor supply curve. L1 is the quantity of labor demanded; L2 is the quantity supplied; the shortfall is (L1 – L2). The resulting shortage of labor will cause the nominal wage rate to
rise until equilibrium is restored in the labor market. This increase in the nominal wage will cause the
SRAS curve to shift to the left until output is back to its starting level at Y*. Equilibrium is E2.
Note the result: Any movement away from equilibrium in the labor market will be temporary, and
the economy will return to that level of output consistent with labor market equilibrium with a different (higher, in this case) price level (P2) and nominal wage rate (W1) such that the original equilibrium real wage rate is restored. The vertical line at this full employment level of output, Y*, is our
long-run aggregate supply (LRAS) curve.
For a decline in AD that creates a short-run equilibrium level of output that is below full-employment GDP, the result is the same. The difference is that there is a surplus of labor in the short run,
which causes the nominal wage to fall and thus shift the SRAS curve to the right until equilibrium is
restored at full-employment GDP. The labor market will also be in equilibrium.
Economic Growth
Now we will extend the SRAS, LRAS, AD model to illustrate the process of economic growth.
We know that we can use the production possibilities curve model to demonstrate growth, defined
as an increase in the capacity of the economy to produce GDP. In this model, we can show that an
increase in resources, an increase in the stock of capital or an in increase in technology will cause the
PPC to shift outward.
We can show this same result in our AD and AS model. Appendix Figure 4.4 presents the following
analysis.
An increase in the stock of capital or an increase in technology will cause the production function
for the economy to shift (rotate) upward to F1, showing a greater level of output for every level of
labor employed. This upward rotation of the production function will raise the slope of the production function. This slope is the marginal productivity of labor, which is the labor demand curve in a
perfectly competitive labor market. Thus the labor demand curve will shift upward to LD1. The labor
demand curve increases because every unit of labor will have more capital (or technology) to work
with so its productivity will be higher.
This upward shift in the labor demand curve will create a higher equilibrium real wage (W1 / P1)
and a higher equilibrium level of employment (L1) in the labor market. Since the position of the
LRAS curve is based upon the equilibrium level of employment, you can trace through the model
from this new equilibrium employment up to the new higher production function to determine the
position of the new LRAS curve to the right of the original LRAS curve. This is the increase in the
productive capacity of the economy. The new LRAS is labeled LRAS1.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
473
UNIT
3 Macroeconomics
LESSON 4
Appendix Figure 4.4
New LRAS with Increase in Capital Stock
F1(L, K1, T)
F(L, K, T)
Y
REAL GDP
REAL GDP
Y2
Y1
QUANTITY OF LABOR
REAL GDP
REAL WAGE
LS
W1 / P1
W/P
LD1
PRICE LEVEL
LRAS LRAS1
SRAS
SRAS1
P
P1
AD
LD
L L1
QUANTITY OF LABOR
Y*
Y*1
REAL GDP
Since the SRAS curve was derived from the labor demand curve, there will also be a new SRAS
curve with the nominal wage rate constant, which lies to the right of the original SRAS curve. The
new short-run equilibrium between the new SRAS curve and the fixed AD curve will create a lower
equilibrium price level. Eventually, the economy will be in LR equilibrium where AD = SRAS = LRAS
and the labor market is back in equilibrium. The new SRAS is labeled SRAS1 and intersects with the
AD and LRAS1 curve.
We show the derivation of the new SRAS after an increase in labor demand in Appendix Figure 4.5.
To determine one point on the new SRAS curve, you hold the real wage constant to determine a
level of employment on the new labor demand curve. The new amount of labor demanded is L2.
From there you can trace through the model using the new production function to determine the
level of output, Y2, at the original price level for that nominal wage rate. This gives you one point on
the new SRAS curve, labeled A, and allows you to approximate the balance of the new SRAS curve for
a fixed nominal wage rate.
474
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
LESSON 4
Appendix Figure 4.5
SRAS for Increase in Labor Demand
Y1
F1(L, K1, T)
Y
REAL GDP
REAL GDP
F(L, K, T)
QUANTITY OF LABOR
REAL GDP
REAL WAGE
LS
W1 / P1
W/P
LD1
PRICE LEVEL
LRAS
SRAS
P
A
SRAS1
AD
LD
L
L2
QUANTITY OF LABOR
Y*
REAL GDP
Y2
The intersection of the SRAS1 and AD curves is at a new lower price level. This lower price level
will increase the real wage toward the new higher equilibrium real wage rate in the labor market. If
the short run AD-SRAS equilibrium output level is below full employment, there will be a surplus of
labor, which will in time cause the nominal wage rate to decline. This decline in the nominal wage
rate will cause the SRAS curve to shift to the right until the economy is back in long-run equilibrium
where aggregate demand, short-run aggregate supply and long-run aggregate supply intersect, and
the labor market is back in equilibrium.
An increase in the supply of labor will also cause the LRAS curve to shift to the right since it will
create a new, higher equilibrium level of employment. The difference here is that the production
function and the labor demand curve are fixed. Thus the SRAS curve will not shift with the shift of
the LRAS. Since only the labor supply curve increased, there will now be a surplus of labor and a new
lower equilibrium real wage. The nominal wage will then fall, causing the SRAS curve to shift to the
right until equilibrium is restored in the labor market and in the output market. The new output
equilibrium will, given a fixed AD curve, be at a lower price level. Since the real wage must also be
lower, the nominal wage must fall more than the decline in the price level at the new LR equilibrium.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
475
UNIT
3 Macroeconomics
LESSON 4 ■ ACTIVITY 24
Answer
Key
An Introduction to Short-Run Aggregate Supply
Part A
Why Can the Aggregate Supply Curve Have Three Different Shapes?
Figure 24.1
REAL GDP
SRAS
REAL GDP
PRICE LEVEL
SRAS
PRICE LEVEL
PRICE LEVEL
Possible Shapes of Aggregate Supply Curve
SRAS
REAL GDP
1. Under what conditions would an economy have a horizontal SRAS curve? When there are a lot of
unemployed resources or a constant price level as in a recession or depression
2. Under what conditions would an economy have a vertical SRAS curve? AS is vertical when real
GDP is at a level with unemployment at the full-employment level and where any increase in
demand will result only in an increase in prices. The economy is unable to produce any more goods
and services for a sustainable period of time.
3. Under what conditions would an economy have a positively sloped SRAS curve? In this range,
resources are getting closer to full-employment levels, which creates upward pressure on prices.
The upward pressure on prices is caused by rising costs of doing business. Sticky wages and /or sticky
prices cause the AS curve to be positively sloped. Wages and prices may be slow to adjust, or sticky, if
firms or workers lack information.
476
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
LESSON 4 ■ ACTIVITY 24
Answer
Key
4. Assume AD increased. What would be the effect on real GDP and the price level if the economy
had a horizontal SRAS curve? A positively sloped SRAS curve? A vertical SRAS curve? With a horizontal SRAS curve, an increase in AD results in an increase in real GDP and no change in the price
level. With a positively sloped SRAS curve, an increase in AD results in increases in real GDP and
the price level. With a vertical SRAS curve, an increase in AD results in no change in real GDP and
an increase in the price level.
5. What range of the SRAS curve do you think the economy is in today? Explain. Answer depends on
current economic conditions.
Part B
What Shifts the Short-Run Aggregate Supply Curve?
Figure 24.2
Shifts in Short-Run Aggregate Supply
B
C
PRICE LEVEL
A
REAL GDP
6. Using Figure 24.2, determine whether each situation below will cause an increase, decrease or no
change in short-run aggregate supply (SRAS). Always start at curve B. If the situation would cause
an increase in SRAS, draw an up arrow in column 1. If it causes a decrease, draw a down arrow. If
there is no change, write NC. For each situation that causes a change in SRAS, write the letter of
the new curve in column 2. Move only one curve.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
477
UNIT
3 Macroeconomics
Situation
1. Change in SRAS
(E) Computer technology brings new efficiency
to industry.
➞ ➞ ➞
(F) Government spending increases.
NC
(G) Cuts in tax rates increase incentives to save.
NC
(H) Low birth rate will decrease the labor force
in future.
NC
(I) Research shows that improved schools have
increased the skills of American workers
and managers.
➞
(B) OPEC successfully increases oil prices.
➞ ➞
(A) Unions grow more aggressive;
wage rates increase.
(C) Labor productivity increases dramatically.
(D) Giant natural gas discovery decreases
energy prices.
Answer
Key
LESSON 4 ■ ACTIVITY 24
2. New SRAS Curve
A
A
C
C
C
C
Note: (F) and (G) do not affect the aggregate supply curve. They do shift the aggregate demand curve.
(H) will not affect aggregate supply for 16 years or more.
478
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.