Download Power Point: Aggregate Supply

Aggregate Supply
Chapter 10: “The Aggregate Supply Curve”
Aggregate Supply
Tells us how much is produced in goods
and services in the country.
Determinants of Aggregate Supply





Prices
Wages and prices of raw materials.
Stock of capital
State of Technology
Producer’s expectations
Aggregate Supply
Describes the relationship between the
price index and the Quantity of goods
and services (Real GDP) supplied
Holding all other
determinants of
supply constant
Labor costs are constant in the short run
Wages change when labor contracts expire.
 Workers are reluctant to accept lower wages.
 Employers prefer to fire unskilled workers to
reduce wages of skilled
workers:
Wages
are




Reduce worker turnover:
workers
“sticky”
in theeager to keep their
jobs .
short run
Reduces cost of inexperience and training.
Increases productivity: workers work harder.
Minimum wage laws prevent wages from
falling.
 Unions increase worker’s bargaining power

Important Difference:


Price: what the consumer pays and the
producer receives.
Cost: what the producer pays for raw
materials, labor and other expenses
necessary to produce.
Firms maximize Profits

Labor is the largest cost
Wages are
in the
ofconstant
production
short run
If prices rise while wages remain fixed,
production becomes more profitable and
firms produce more.
Profit = Price
- Cost
same
Aggregate Supply Curves Slopes
Upward
AS
AS(Wage
) )
0fixed
Cause
Price Level
Profit = Price
- Cost
same
Firms will produce
more when prices
increase if profits
increase
Profits increase, if
WAGES do not
increase
Real GDP supplied
Effect
Movement Along Aggregate Supply


When Prices increase, wages (costs)
remain constant, profits increase, firms
produce more.
When Prices decrease, wages (costs)
remain constant, profits decrease, firms
produce less.
Changes in Prices cause a movement
along Aggregate Supply
An increase in wages shifts AS left
AS(Wage1)
Profit
=
Price
- Cost
Price Level
same
P0
Firms produce LESS
when wages increase
Y1
Y0
Real GDP supplied
AS(Wage0)
Improvements in technology, increase
in Stock of Capital & labor force
AS0
Price Level
AS1
P0
Firms produce MORE with
better technology, larger labor
force and stock of capital
Y0
Y1
Real GDP supplied
Direct
Direct
AS1
AS0
P0
Y0
AS0
AS1
P0
Y0
Price Level
Demand increases
when Prices drop:
Move Along
AD = C+ I + G + NX
15
Aggregate Supply – Aggregate
Demand
Aggregate Supply
Price Level
Goods and Services Produced
At this price level all
At this price level
production is sold: no
Aggregate Supply =
accumulation of
Aggregate Demand
inventories
Po
Aggregate Demand
Goods and Services Purchased
GDPo
Real GDP
16
Stagflation
Goods and Services Produced
CPI1
Inflation
CPIo
Unemployment
increases
Recession
GDP1 GDPo
Goods and Services Purchased
CPI0
Inventories rise,
prices drop,
output rises
Deflation
CPI1
GDPo GDP1
Growth
Unemployment
drops
18
Increase Government
Spending
Buy More
Inventories Drop,
prices and output
rise
CPI1
CPIo
Inflation
GDPo GDP1
Growth
Unemployment
drops
19
stock prices fall
Buy
Less
Inventories rise,
prices and output
drop
CPIo
Deflation
CPI1
Unemployment
increases
GDP1 GDPo
Recession
Recession and deflation
Price Level
Recession and inflation
Growth and inflation
Growth and deflation
Price Level
ASo AS1
ASo
1
2
AD1
ADo
ADo
Real GDP
Real GDP
Price Level
Price Level
AS1
ASo
ASo
4
3
ADo
AD1
ADo
Real GDP
Real GDP
21
B
A D
A. Increased
costs
B. Increase
consumption
Which graph best describes the effect of
the following events
C
E F
C. Increase in
labor costs
and increase
in government
spending
D. Increase in
wages
E. Increase in
labor
productivity
F. Lower oil
prices
AS shifts more than AD
AD shifts more than AS
S1
E1
P
S1
S2
E2
E1
S2
E2
D2
D2
D1
D1
GDP
AS and AD increase:
Prices may go up,
down or remain the
same
Output definitely
increase.
AS shifts by the same amount as AD
S1
E1
S2
E2
D1
D2
2. Recession caused by a decrease in
consumption and increase in productivity
2
3
3. Recession &
deflation mainly
caused by drop in
AD
5
Which graph best describes the effect of the
following events
4.Growth & inflation caused mainly by
increase in Government Spending
1. Economic growth and inflation
5.Expansion with deflation
mainly caused by
improvement in technology
1
4
5
Factors that affect Supply
Cost of Production
Wages and prices of
inputs (oil)
Increase
Size of stock of capital
and labor force
Increase
Technology
Improvement
Firms produce less
when costs increase AS
shifts left
Firms produce more
with a larger labor force
or a larger stock of
physical capital: AS
shifts right
Firms produce more
with better technology:
AS shifts right.
What Causes Inflation/Deflation?
Prices change when Aggregate Demand
for goods and services runs ahead or lags
behind Production of goods and services
(Aggregate Supply)
26
What Causes Inflation/Deflation?
Prices change when Aggregate Demand
for goods and services runs ahead or lags
behind Production of goods and services
(Aggregate Supply)
27
Increase
Production
Produce
More
Aggregate
Supply
Supply larger
than Demand:
Inventories rise,
Firms cut prices
Po
P1
Aggregate Demand
Demand
GDPo
GDPo GDP1 Supply
Supply
28
Determining the Price Level
P
As prices rise,
real wealth
drops, C drops,
AD drops.
45
AS
As prices rise,
real wealth
drops, C drops,
AE drops.
6,400
100
6,000
5,600
80
AD
0
5,600
Y
6,000
6,400
5,600
6,000
Y=AE AE
Excess Demand: AE > Y, inventories drop, firms
increase both production and prices.
Price
index
Determining the Price Level
As prices drop,
real wealth rise,
C rise, AD rise.
120
AS
As prices drop,
real wealth
rises, C rises,
AE shifts up.
6,400
6,000
5,600
100
AD
0
5,600
AE
6,000
Y=AE
6,400
6,000 6,400
Excess Supply: AE < Y, inventories
Y
rise, firms decrease both
production and prices
45
The Shape of the Aggregate
Supply Curve
The book uses an upward sloping AS curve…is
this always the case? Why is it upward
sloping?
31
The Shape of the Aggregate
Supply Curve
AS: describes the reaction of firms to changes
in demand.
32
The Effect of an Increase in
Unemployed
workers:
Lower Unemployment:
wages
Aggregate
Demand
Only
PriceslowMinimal
wages
Unemployment
rise
Excess
easy
rise
excess costs
capacity
Lesscapacity:
excessno
capacity:
to
produce
more.
riseNo
as Unemployment:
firms produce more. To
Firms
do
NOTrise
raise
cover
increase
in faster
costs, firms and
Lower
Unemployment
wages
prices butraise
instead
prices
less
excess
capacity
No
excess
increase
output
capacity: Firms
cannot produce
Prices Increase
more, only
increase prices
Prices do not change
Unemployment and Excess Capacity
Output Increases
Output
Output Increases
can not increase
The book uses an upward sloping AS
curve…is this always the case?
 NO.
The reaction of firms depends on where
the economy is along the business cycle.
 During
a Recession (high Unemployment and
Excess Capacity) AS is horizontal
 Wages do not rise: kept low by unemployment.
 Firms can increase production without raising
prices.
34
Why would AS slope upwards?
As the economy recovers, unemployment dropws
and there is less excess capacity: AS is upward
sloping
 Firms can increase output
 But costs rise: lower unemployment means
hiring workers becomes more expensive and
equipment breaks down more often.
Firms increase both
production and prices (to
cover increase in costs).
35
The book uses an upward sloping AS
curve…is this always the case?
NO. The reaction of firms depends on where the
economy is along the business cycle.
At full employment with zero cyclical Unemployment and
NO Excess Capacity: AS is vertical.
Firms can NOT increase production.
 And costs rise: zero unemployment means that firms
must hire workers away from other firms and
equipment breaks down more often.
Firms increase prices
36
The Self Adjusting Mechanism
Prices rise, gap closes: purchasing power decreases AD decreases
Potential GDP
AS(W2)
Economy’s self
correcting
AS(W1)
mechanism to
close an
inflationary gap
Inflationary Gap
Price level
P1
Labor market shortages:
Excessive spending is
Difficult for firms to hire,
reduced by an increase in
easy for workers to win
prices
wage increases
P0
AD0
4,000 5,000
Real GDP
Wages
rise: AS
shifts left
Which graph describes the effect of an
increase in Consumption
Near Full
employment
Near Full
employment
Below Full
Employment
Below Full
Employment
Adjusting to a Recessionary Gap
Prices fall, gap closes: purchasing power
increases, AD increases
Unemployment: easy for
firms to hire, difficult for
workers to win wage
increases
wages
and
prices
do
Potential
GDP
Price level
If
not fall: self correcting
AS(W
1)
Recessionary gaps
occur
mechanism operates
because wages
and Gap
Recessionary
only weakly to cure
prices do not fall. AS(W2)
recessions
Wages fall:
AS shifts
right
P1
P2
AD0
5,000
Real GDP
6,000
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.