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Aggregate Supply
CHAPTER
26
© 2003 South-Western/Thomson Learning
1
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
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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
3
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
4
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
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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 longterm contracts remain in force for
extended periods
6
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
7
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
8
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
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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
10
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
11
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
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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
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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
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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
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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
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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
17
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
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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
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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
20
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
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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
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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
23
Exhibit 1:Short-Run Aggregate Supply Curve
Potential
output
SRAS 130
The expected price level is 130;
the SRAS is based on that
expected price level.
P ric e le vel
If the price level turns out to be
130 as expected, producers
supply the economy’s potential
level of output, $10.0 trillion.
140
130
a
120
0
10.0
Real GDP (trillions of dollars)
24
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
25
Exhibit 1: Short-Run Aggregate Supply Curve
Potential
output
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.
140
P ric e le ve l
The slope of the short-run
aggregate supply curve
depends on how sharply the
cost of additional production
rises as aggregate output
expands.
SRAS 130
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.
130
a
120
0
The short-run
aggregate supply
becomes steeper
as output
increases because
resources become
more costly as
output increases
10.0 Real GDP (trillions of dollars)
26
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
27
Exhibit 2: Expansionary Gap
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.
Price level
The initial short run supply curve for the
expected price level of 130 is SRAS130 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.
Potential
output
SRAS130
140
b
135
AD
130
a
0
10.0
10.2
Expansionary gap
Real GDP
(trillions of
dollars)
28
Exhibit 2: Expansionary Gap
Potential
output
Price level
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.
SRAS 140
What happens in the long run? The
long run is a period during which
135
firms and resource suppliers have
the time to renegotiate their
agreements: nominal wages
increase, firms’ production costs
increase, and the short-run aggregate 130
supply curve shifts leftward to
SRAS140 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.
0
SRAS 130
c
140
b
AD
a
Real GDP
(trillions of dollars)
10.0
10.2
Expansionary gap
29
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
30
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
31
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 lower than expected price
level translates into a higher real
wage in the short run.
SRAS130
130
Price level
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.
Potential
output
a
125
d
e
120
AD
0
9.8
10.0
Contractionary gap
32
Exhibit 3: Contractionary Gap
The SRAS curve shifts
rightward until it intersects the
aggregate demand curve,
where the economy produces
its potential output at SRAS120.
The economy will reach long-run
equilibrium at point e.
Potential
output
SRAS130
SRAS120
130
Price level
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
a
125
d
e
120
AD
0
9.8
10.0
Contractionary gap
33
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
34
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
35
Exhibit 4: Long-Run Aggregate Supply Curve
The initial price
level of 130 is
determined by the
intersection of AD
with the long-run
aggregate supply
curve.
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.
Potential output
LRAS
140
b
130
a
120
c
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.
AD'
AD
AD''
0
10.0
Real GDP (trillions of dollars)
36
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
37
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
38
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
39
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
40
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
41
Exhibit 6: Change in the Supply of Resources
LRAS
LRAS'
Price level
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'
0
10.0 10.5
Real GDP
(trillions of dollars)
42
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
43
Exhibit 7: Beneficial Supply Shock
Price level
LRAS LRAS'
SRAS 130
130
a
125
SRAS 125
b
AD
0
10.0
Here, the beneficial supply
shock is assumed to be a
technological breakthrough,
which shifts the SRAS from
SRAS130 to SRAS125 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.
10.2
Real GDP
(trillions of dollars)
44
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
45
Exhibit 8: Adverse Supply Shock
LRAS'' LRAS
SRAS 135
Price level
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
SRAS 130
c
135
a
130
AD
0
9.8
10.0
Real GDP
(trillions of dollars)
46