Download Price level

Aggregate Supply
Tells us how much is produced in
goods and services in the country.
Determinant of Aggregate Supply





Prices
Wages and Prices of Other Inputs
(raw materials)
Capital stock
State of Technology
Expectations
Aggregate Supply
Relationship between the price
level and the Quantity of Real
GDP supplied
Holding: Wages,
Holding all other
Prices of Other Inputs
determinants
of
Capital stock
supply
constant
State
of Technology
and
Expectations constant
Aggregate Supply
Shows the relationship between
Prices and Output Supplied
Important Difference:


Price: what the producer sells
output for. The price is paid by the
ultimate user
Cost: what the producer pays for
raw materials, labor and other
expenses necessary to produce.
When costs rise, each unit is more expensive
to produce, the producer must raise price to
cover the increase in cost.
The change
The change in price
in costs
occurs as a result of
occurs first
the increase in cost.
Wages are rigid, “sticky” in the
short run
Labor union contracts, wages change
only when the contract expires.
 Minimum wage laws
 Workers do not accept lower wages
easily.
 Firms are reluctant to cut wages afraid
to lose most productive workers and
negatively affect productivity and
morale.
 Firms and workers know the recession
will not last and thus “wait out” the bad
times refusing to budge.

How do firms decide how much to produce?




Firms maximize profits
Profit per unit = Price per unit – Cost per unit.
Labor costs (wages and salaries) are “sticky” in
the short run.
If labor is the ONLY cost of production then
•When Prices increase, given that wages (costs) remain
If prices
while
wages
other
constant,
profitsrise
increase:
the firm
reacts byand
producing
more
units
costs are fixed, production becomes
•WhenThe
PricesAggregate
decrease, givenSupply
that wages Curve
(costs) remain
slopes
more
profitable
and
firms
produce
constant, profits decrease : the firm reacts by producing fewer
upward in more.
the short run: higher
units
prices result in higher production
Aggregate Supply Curves Slopes
Upward
Price Level
Short Run Aggregate Supply= SRAS
Real GDP supplied
Movement Along Aggregate
Supply
When Prices increase, given that
wages (costs) remain constant,
profits increase and the firm will
react by producing more units
 When Prices decrease, given that
wages (costs) remain constant,
profits decrease and the firm will
react by in
producing
fewer
units
Changes
Prices cause
a movement
along Aggregate Supply

Shifts in the Aggregate Supply
Curve




Prices
Wages and prices
of Other Inputs
Capital stock:
labor and Physical
capital
Technology/Produ
ctivity
AS shifts to the left
as firms produce less
when their costs
increase.
AS shifts to the right
as firms produce
more with a larger
labor force or a
larger stock of
physical capital.
AS shifts to the right
as firms produce
more with better
technology.
Determining the Price Level
The
price level is the result of the
interplay between Aggregate Demand
and Aggregate Supply.
To determine the price level, we
must put Aggregate Demand and
Aggregate Supply together.
Price
index
120
Determining the Price Level
Excess Supply: AE < Y,
Aggregate
inventories rise, firms
AS Supply
decrease both production
and prices
EQUILIBRIUM: AE = Y,
inventories unchanged,
firms do not change
production or prices
100
80
0
Aggregate
AD
Demand
Excess Demand: AE > Y,
6,400
5,600
6,000
inventories drop, firms
increase both production
AEY Y=AE AE
Y
and prices.
Real GDP
If G, I, a, NX increase
AE line Shifts up
Aggregate Expenditures
AE1= C+I+G+NX
45
Price level
Equilibrium Income increases
Aggregate demand increases
AE0=
C+I+G+NX P
0
AD1
AD0
Y0
Real GDP
Y1
Y0
Real GDP
Y1
The Aggregate Supply Curve
Only Prices
rise
At Full Employment
Potential GDP
Closer to Full Employment
Prices Increase
Prices do
Not change
Below full employment
Output Increases
Output can
Increases
not increase
Smallest effect
Largest
effect
For which segment does an increase in demand
has the smallest/largest effect on output?
The Self Adjusting Mechanism
How is it supposed to work?
Adjusting to an Inflationary Gap
Prices rise, inflationary gap closes: purchasing power of wealth
decreases, AD decreases ( a movement up along AD)
AS2
Potential GDP
AS
1
Economy’s
self
correcting
Labor market shortages:
Difficult
for firms to hire,
mechanism to
close
easy for workers to win
an inflationary
gap
Price level
P1
wage increases
Inflationary Gap
100
AD0
4,000 5,000
Real GDP
Wages rise: AS shifts left
as labor costs rise
Adjusting to a Recessionary Gap
Unemployment: easy for
Price level
If wages and
prices
dodifficult for
firms
to hire,
not fall: selfworkers
correcting
to win wage
mechanism
operates
increases
Potential GDP
only weakly to cure
AS1 AD increases
Prices fall, gap closes: purchasing power increases,
recessions
AS2
100
Recessionary Gap
P1
AD0
5,000
Real GDP
6,000
Wages fall: AS shifts
right as labor costs
decrease
The effect of an Increase in
1. Economy starts at Potential GDP
Demand
2. Inflationary gap appears
3. Prices rise, output drops back to Potential
GDP
Economy ends at Potential GDP
Potential GDP =
LRAS
SRAS
AS2 2
AS1
In the Short Run AS has a positive slope
3
P2
Price level
2
In the Long Run AS is Vertical at Potential GDP
AS shifts left as labor
Inflationary Gap costs rise
AD increases
In the long run (ignoring the
temporary move to point 2)
the economy always ends
up at potential GDP
P1
P0
1
AD1
AD0
4,000 5,000
Real GDP
Does the US economy has a self
correcting mechanism?
YES
 When the economy experiences an inflationary
gap, wages increase, shifting the AS left,
increasing prices and thus slowing down AD.
 When the economy experiences a recessionary
gap, wages decrease, shifting the AS right,
decreasing prices and thus increasing AD.
BUT
 This mechanism works slowly so there is an
argument to be made in favor of stabilization
policies.
Using the Model
Stagflation from a Supply Shock:
Rising Energy Prices shift the AS left
Stagflation from a Supply Shock
AS2
AS1
Higher prices & lower
output: stagflation
Price level
P1
100
Oil Prices rise: AS shifts
left
AD0
5,000
Real GDP
1.
Changes in wealth


2.
Changes in consumer
expectations


3.
shift the consumption function.
Example: value of stocks,
bonds, consumer durables.
Shift the consumption function.
Example: Pessimistic
expectations decrease
autonomous consumption.
Prices

Affect the purchasing power of
assets.
Shift up in AE line
Shift right in AD line
Shift up in
AE line
Movement
Along AD
line





Interest Rates:
Tax Incentives:
Technical Change:
Expectations about the
strength of demand:
Political Stability and the
rule of law:
Shift AE line
Shift AD line
Government expenditures
are determined by the
budget process: The
president, Congress and
the Senate.
Fiscal Policy
Shift AE line
Shift AD line




National Incomes
GDP of other
countries
Relative Prices
Exchange Rates
Shift AE line
Shift AD line
Shifts in the Aggregate Supply
Curve




Prices
Wages and prices
of Other Inputs
Capital stock:
labor and Physical
capital
Technology/Produ
ctivity
AS shifts to the left
as firms produce less
when their costs
increase.
AS shifts to the right
as firms produce
more with a larger
labor force or a
larger stock of
physical capital.
AS shifts to the right
as firms produce
more with better
technology.
Which graph describes the effect of an
increase in Autonomous Consumption
Near Full
employment
Near Full
employment
Below Full
Employment
Below Full
Employment
B
A. Increased oil
prices
A
D
E
C
B. Increase in
autonomous
consumption
C. Adverse
supply shock
with increase
in government
spending
D. Rising wage
rates
E. Increase in
labor
productivity
Which graph best describes the effect of the
following events
2. Recession caused by a decrease in
consumption and increase in productivity
2
3
3. Recession &
deflation mainly
caused by drop in
AD
5
4.Expansion
with
inflation
Which
graph
best caused
describes the effect of the
mainlyfollowing
by increase
in AD
events
1. Economic growth and inflation
5.Expansion with deflation
mainly caused by increase
in AS
1
4
5
Questions to prepare for the Quiz
Draw both an AE – 45degree line and
an AS-AD diagram to show the
effect on GDP and the price level
resulting from the following
events:
1. A Decrease in interest rates.
2. Oil prices drop (a drop in costs of
production).
3. Pessimistic business forecasts lead
businesses to reduce their planned
investment.
Questions to prepare for the quiz
4.
5.
6.
7.
8.
9.
10.
11.
A tax cut on business.
Increase in government spending.
A major increase in home prices
U.S pulls troops out of Iraq.
Manufacturers rush to acquire the
new technology for producing zero
emissions cars.
Overall prices increase (CPI
increases)
Europeans impose tariffs on
imported goods
U.S. retaliates by imposing tariffs
on European goods
Recessionary/Inflationary Gap?
If G, I, a, NX increase
AE line Shifts up
Aggregate Expenditures
AE1= C+I+G+NX
45
Price level
Equilibrium Income increases
DY = DG (1/1-MPC)
AE0=
C+I+G+NX P
0
AD1
DY = DG (1/1-MPC)
Y0
Real GDP
Y1
AD0
Y0
Real GDP
Y1
Inflation Reduces the Size of the Multiplier
AD Shifts by the full multiplier amount
DY = DG (1/1-MPC)
If firms DO
NOT raise
prices
AS
1
Excess Demand: AE > Y,
inventories drop, firms
increase both production
and prices.
Price level
P1
P0
AD1
AD0
Y0
Real GDP
Y1
Y2
If firms DO raise
prices, the increase in
output is SMALLER
than given by the
multiplier formula
The Aggregate Supply Curve
Only Prices
rise
At Full Employment
Closer to Full Employment
Prices Increase
Prices do
Not change
Below full employment
Output Increases
by full multiplier
Output
Outputcan
Increases
not increase
by
noless
multiplier
than multiplier
effect
Smallest multiplier effect
Largest
multiplier
effect
Which segment has the smallest/largest multiplier
effect?
a. Decrease in interest rates d. a tax cut on purchase of
equipment g. rush to acquire new technology:
increases Investment, AE, Equilibrium Output, AD, Prices and
GDP.
AS0
AE1
AE0
P1
P0
AD1
AD0
Y0
Y1
GDP0
GDP1
c. Pessimistic forecast: Decreases Investment, AE, Equilibrium
Output, AD, Prices and GDP.
AS0
AE0
AE1
P0
P1
AD1
AD0
Y1
Y0
GDP1 GDP0
e. Increase in home prices: increases real value of wealth ,
consumption, AE, Equilibrium Output, AD, Prices and GDP.
AS0
AE1
AE0
P1
P0
AD1
AD0
Y0
Y1
GDP0
GDP1
e. Overall Prices Decrease: increases wealth (in real terms),
increase in Consumption, AE, Equilibrium Output, movement
along AD
AS0
AE1
AE0
P0
P1
AD1
AD0
Y0
Y1
GDP0
GDP1
f. U.S. pulls troops out of Iraq: Decreases Government Spending,
AE, Equilibrium Output, AD, Prices and GDP.
AS0
AE0
AE1
P0
P1
AD1
AD0
Y1
Y0
GDP1 GDP0
e. U.S. imposes tariffs on European goods: Decreases Imports,
increases net exports, AE, Equilibrium Output, AD, Prices and
GDP.
AS0
AE1
AE0
P1
P0
AD1
AD0
Y0
Y1
GDP0
GDP1
i. Europeans impose tariffs on imported goods: Decreases
Exports, AE, Equilibrium Output, AD, Prices and GDP.
AS0
AE0
AE1
P0
P1
AD1
AD0
Y1
Y0
GDP1 GDP0
An adverse supply shock: oil prices increase, wages increase
AS1
AS0
P1
P0
AD0
GDP1 GDP0
A favorable supply shock (drop in cost of production or
increase in productivity): wages drop, oil prices drop
AS0
AS1
P0
P1
AD0
GDP0 GDP1