Download Classical Macroeconomics

The Theory of Aggregate Supply
Short Run Aggregate Supply Curve
Learning Objectives
• Understand the determinants of output.
• Understand how output is distributed.
• Learn how to derive the short run aggregate
supply curve.
• Learn how to shift the short run aggregate
supply curve.
• Learn how macroeconomic policy affects
the real goods market and the labor market.
Aggregate Supply
• Aggregate supply: The amount of output
supplied by firms in the economy at any
given price level.
• Aggregate supply curve: The relation
between the price level and the total amount
of output that firms supply.
Aggregate Supply: Short Run
• In the long-run, the aggregate supply curve is
vertical.
– Prices are completely flexible: Output is fixed.
• In the short-run, the aggregate supply curve
may be horizontal or upward sloping.
– Horizontal aggregate supply curves exist when
prices are completely inflexible and output is
totally flexible.
– Upward sloping aggregate supply curves imply
both price and output flexibility.
The Short Run Aggregate Supply
Curve: Derivation
• Assumptions:
– The nominal wage is fixed at a particular value.
– The real wage changes as the price level
changes, rising as the price level falls and falling
as the price level rises.
– Worker behavior is ignored for now.
Production: Definitions
• Production is the activity of transforming
resources into finished goods.
• Technology is a method for transforming
resources into finished goods.
• Factors of production are inputs used in the
production process such as labor and
capital.
Determining Total Output
• An economy’s output of goods and services,
GDP, depends on:
– The quantity and quality of inputs or factors
of production.
– The economy’s production function.
Factors of Production
• Factors of production are the inputs used to
produce goods and services.
• The two most important factors of
production are labor (L) and capital (K).
Production Function
• The production function is a relationship
between the quantities of factors of
production employed by all firms in the
economy and the total production of real
output by those firms, given the technology
available.
• Y = F(K, L)
The Production Function
Y
Y = F(L,K)
Y = F(L,K) says that the total amount of
real output is a function of the amount
of labor employed by all firms in
the economy.
Capital is assumed to be fixed.
0
L
The Production Function
• The production function is concave.
– This means that the production function’s slope
rises at a decreasing rate.
• For every increase in labor, output increases by
smaller amounts.
– The production function is drawn this way
because we are assuming the law of
diminishing returns causes each additional unit
of labor to produce less output.
The Marginal Product of Labor
• The slope of the production function is /\Y//\L
or the additional amount of output produced
when one more worker is added.
• Another name for the change in output divided
by the change in labor is the marginal product
of labor (MPL).
• Since the production function increases at a
decreasing rate, MPL must slope down.
The Marginal Product of Labor
Y
/\L2
/\Y2
Y=F(L)
Note that the change in L is the same but
the change in Y is smaller at the higher
level of L, reflecting the impact of the
Law of Diminishing Returns.
/\Y1
/\L1
0
MPL
0
L
Note that the marginal product of labor
is drawn sloping down, reflecting the fact
that as more workers are added the
marginal product of the next worker
decreases.
MPL
L
Distribution of Income
• The distribution of national income is
determined by factor prices.
• Factor prices are the amounts paid to the
factors of production.
• How does a competitive firm decide how
much to pay its factors of production?
Profits and the Competitive Firm
• A profit maximizing, competitive firm takes
the product price and the factor prices as
given and chooses the amounts of output,
labor and capital that maximize profits.
– How does the firm choose?
Profit Maximizing Math
• Labor Demand




/\Profit = /\Revenue - /\Cost
/\Profit = (P x MPL) - w = 0
P x MPL = w
Labor Demand
MPL = w/P
Demand for Labor
• w = P x MPL
– A profit-maximizing competitive firm hires labor
up to the point where the nominal wage just equals
the value of the marginal product of labor.
• w/P = MPL
– A profit-maximizing competitive firm hires labor
up to the point where the real wage just equals the
marginal product of labor.
W
Alternative Demand for Labor
Schedules
A profit maximizing firm employs labor
to the point where the VMP is equal to
the nominal or money wage.
0
P x MPL = LD(P)
L
w/P
A profit maximizing firm employs labor
to the point where the marginal product
of labor is equal to the real wage.
MPL = LD
0
L
Demand for Labor
• The value of the marginal product of labor
schedule for a perfectly competitive firm is
that firm’s labor demand schedule.
– It shows how many units of labor the firm
demands at any given nominal wage w.
• The marginal product of labor schedule for a
perfectly competitive firm is that firm’s labor
demand schedule.
– It shows how many units of labor the firm
demands at any given real wage w/P.
Nominal Wages and Real Wages?
• The nominal wage is the money wage paid.
• The real wage in the nominal wage adjusted by
the price level as measured by the average
price of goods and services.
– The real wage reflects the true purchasing power
of the worker’s income.
Putting It All Together
Deriving Aggregate Supply
What Does All This Mean for
Aggregate Supply?
• Aggregate supply is the total quantity of goods
and services produced by an economy.
• The aggregate supply curve is a schedule
relating the total supply of all goods and
services in the economy to the general price
level.
• What does the aggregate supply curve look
like?
The Model Components
• The production function relates output
produced to labor employed.
• Labor employed is determined by labor
demand.
• The balancing line transfers output from the
vertical axis to the horizontal.
• Aggregate supply will show the relationship
between output and the price level.
Y
Y=F(L)
Y
Production Function
0
w/P
Balancing Line
L 0
Y
P
Labor Market
Aggregate Supply
LD
0
L 0
Y
Sticky Wage Model
• When the nominal wage is set, a rise in the
price level lowers the real wage.
• The lower real wage encourages firms to hire
more labor.
• The additional labor produces more output.
• Y = Y + a(P - Pe) a > 0
– Output deviates from its natural rate when the price
level deviates from the expected price level.
Aggregate Supply Curve with Sticky
Wages
• Assumptions:
– Workers and firms bargain over and agree on the
nominal wage before they know what the price
level will be when the agreement takes effect.
– After the nominal wage is set and before workers
are hired, firms learn the price level. Workers do
not.
– Employment is determined by the labor demanded
by firms.
Deriving Aggregate Supply
• Let the price level be P1.
– At the price level P1, the real wage is w/P1.
– At the wage w/P1, firms are willing to hire L1
workers.
• Given L1 workers, the production function
shows that output equals Y1.
• The combination Y1, P1 is one point on the
aggregate supply curve.
Y=F(L)
Y
Y
Y1
0
w/P
L 0
P
L1
P1
w/P1
Y1
Y
.
LD
0
L1
L 0
Y1
Y
Deriving Aggregate Supply
• Let the price level be P2.
– At the price level P2, the real wage is w/P2.
– At the wage w/P2, firms are willing to hire L2
workers.
• Given L2 workers, the production function
shows that output equals Y2.
• The combination Y2, P2 is another point on the
aggregate supply curve.
Y=F(L)
Y
Y
Y1
L 0
P
0
w/P
Y
Y1
AS
.
P2
P1
w/P1
.
w/P2
LD
0
L1 L2
L 0
Y1
Y
Aggregate Supply Curve
• The aggregate supply curve is upward
sloping because as the real wage
decreases firms are willing to employ more
workers.
– As more workers are employed, output
increases.
Determination of the Equilibrium
Real Wage
Equilibrium Real Wage
• The equilibrium real wage is the real wage
rate for the point at which the labor supply
and demand curves intersect, so there is no
pressure for change.
Labor Supply
w/P
Individuals choose how many hours
to work.
LS
As the real wage rises, leisure becomes
more expensive relative to the goods
and services available, so people choose
to work more.
w/P
0
LS
LS
As the real wage falls, leisure becomes
less expensive relative to the goods and
services available, so people choose to
work less.
Equilibrium: The Labor Market
w/P
LS
At w/P labor demand just
equals labor supply.
w/P
The labor market clears.
LD
0
L
L
Labor Market Changes and
Aggregate Supply
• Factors that shift labor demand and labor
supply also cause cause fluctuations in the
level of output.
– Labor demand shifts with changes in
technology/productivity.
– Labor supply shifts with changes in taxes,
preferences, and wealth.
Change in Technology
• New technology increases productivity.
– The production function shifts up.
– The labor demand curve shifts to the right.
• The increase in demand for labor increases
the real wage, causing an increase in labor
supply along the labor supply curve.
• Aggregate supply increases.
– At the price level, P1, more output is produced.
Y
Y2
Y2=F(L)
2
Y
Y1=F(L)
Y1
1
L 0
0
w/P
Y
P
AS1
LS
AS2
2
w2/P1
w1/P1
0
P1
1
LD1
L1
LD2
L
0
Y1
Y2
Y
Factors that Shift Labor Supply
• Taxes:
– Taxes reduce labor supply by lowering the
wage received by households.
• An increase in the tax rate shifts the labor supply
curve to the left.
• The decrease in labor supply increases the nominal
wage, causing firms to move up along the labor
demand curve and hire fewer workers.
• Equilibrium employment and aggregate supply
decrease.
Y=F(L)
Y
Y
Y1
Y2
L
0
w/P
LS2
LS
0
P
Y
Y2 Y1
1
AS2
AS1
w/P1
w/P1
P1
LD
0
L2 L1
L
0
Y2 Y1
Y
Factors that Shift Labor Supply
• Taxes:
– Decreases in taxes increase the labor supply by
raising the wage received by households.
• A decrease in the tax rate shifts the labor supply
curve to the right.
• The increase in labor supply decreases the nominal
wage, causing firms to move down along the labor
demand curve and hire more workers.
• Equilibrium employment and aggregate supply
increase.
Factors that Shift Labor Supply
• Preferences
– A change in worker preferences with respect to
labor supply shifts the labor supply curve.
• If workers decide to work more, the labor supply
curve shifts to the right.
• The increase in labor supply decreases the nominal
wage, causing firms to move down along the labor
demand curve and hire more workers.
• Equilibrium employment and aggregate supply
increase.
Y=F(L)
Y
Y
Y2
Y1
L 0
P
0
w/P
Y1 Y2
LS1
Y
AS1
AS2
LS2
P1
w1/P1
w2/P1
LD
0
L1 L2
L 0
Y
Y1 Y2
Factors that Shift Labor Supply
• Wealth:
– An increase in wealth reduces labor supply by
decreasing the need to work.
• An increase in the wealth shifts the labor supply
curve to the left.
• A decrease in the wealth shifts the labor supply
curve to the right.
– However, as the USA has become wealthier,
labor supply has not decreased. Why?
Labor Supply and Wealth
• As people become wealthier, they have an
incentive to consume more leisure.
– This is known as the wealth effect.
• But, as the real wage rises, people have an
incentive to work more.
– This is known as the substitution effect.
• The employment rate has been roughly constant
because the substitution effect and wealth effects
balance out over time
Expansionary Government Policy
A Short-Run Analysis
Equilibrium
LRAS
P
SRAS0(W0,LD0)
At point B, the model is in longrun equilibrium and short-run
equilibrium.
AD = SRAS = LRAS
P0
0
B
Yfemp
The equilibrium price level is P0
and the full employment
equilibrium output is Yfemp
AD0
Y
Fiscal or Monetary Expansion
Higher planned spending by the
SRAS0(W0,LD0) government or increases in the
money supply shift AD0 to AD1.
P
Y3 is the level of output that would
be reached if the price level
did not rise.
P0
B
L
At point L, output increases by
the full amount of the simple
multiplier.
AD1
0
Yfemp Y1 Y3
AD0
Y
Fiscal or Monetary Expansion
P
SRAS0(W0,LD0)
Equilibrium occurs at point C,
where both the price level and
output have risen.
P1
P0
C
L
B
At point C, the real wage has
fallen, so firms are willing to hire
more workers.
AD1
0
Yfemp Y1 Y3
AD0
Y
Fiscal or Monetary Expansion
SRAS1(W1,LD0)
P
SRAS0(W0,LD0)
As workers realize that the real wage
has fallen, they demand a higher
nominal wage.
P2
P1
P0
D
The increase in the nominal wage
causes the SRAS to shift left.
C
L
B
A new equilibrium is established at D.
AD1
0
Yfemp Y1
AD0
Y
Fiscal or Monetary Expansion
P
SRAS3(W3,LD0)
SRAS1(W1,LD0)
SRAS0(W0,LD0)
P3
P2
P1
P0
At point D, the real wage has fallen
again, causing workers to demand
a higher nominal wage.
E
D
C
L
B
As nominal wages increase, the SRAS
shifts left.
AD1
0
Yfemp Y1
AD0
Y
Fiscal or Monetary Expansion
P
SRAS3(W3,LD0)
SRAS1(W1,LD0)
SRAS0(W0,LD0)
P3
P2
P1
P0
Long-run equilibrium is restored at
point E.
E
D
C
L
At this point, the nominal wage has
risen such that W3/P3 = W0/P0.
B
AD1
0
Yfemp Y1
AD0
Y
Long Run Aggregate Supply
• The long-run aggregate supply curve is a
vertical line drawn at the natural level of
real GDP.
– It shows that equilibrium in the labor market
can be achieved at many different price levels
but only a single level of output.
– Long-run equilibrium occurs when labor input
is the amount voluntarily supplied and
demanded at the equilibrium real wage.
LM3
LM2
r
If interest rates do not rise,
Y increases from Y1 to Y4.
5
r4
4
r3
3
r2
If the expansion causes
interest rates to rise from r1
r1
to r2,, Y increases from
Y1 to Y3.
As the expansion causes
the price level to rise from
P1 to P2,, Y increases
from Y1 to Y2.
If workers anticipate the
price level change, Y does
not change, but the price
level rises to P3.
0
LM1
IS/LM-AD/AS
Model
2
1
IS2
IS1
Y1 Y2 Y3 Y 4
Y
P
P3
P2
P1
0
SRAS2
SRAS1
5
1
4
3
AD2
2
AD1
Y1 Y2 Y3 Y 4
Y
Expansionary
Fiscal Policy
r
If interest rates fall to r0,
Y increases from Y1 to Y4.
If interest rates to fall to r1,
Y increases from Y1 to Y3.
As the expansion causes
the price level to rise from,
P1 to P2, Y increases
from Y1 to Y2.
If workers anticipate the
price level changes, Y
does not change, but the
price level rises to P3.
5
1
r3
r1
LM1
LM3
LM2
2
3
4
r0
IS/LM-AD/AS Model
0
Y Y 2 Y3
IS1
Y
Y4
Expansionary
Monetary Policy
P
AD1 AD2
SRAS2
SRAS1
P3
P2
P1
0
5
2
3
4
Y1 Y2 Y3
Y4
1
Y
Cycles and the Real Wage
• Given an unchanging labor demand curve,
employment rises when the real wage falls.
• This suggests that the real wage should be
countercyclical; ie., it should fluctuate in the
opposite direction from employment.
• However, data indicates that the real wage
tends to be slightly procyclical; ie., it rises
when output rises.