Download Chapter 2

7. The Aggregate Supply
Curve
Abel, Bernanke, and Croushore
(chapters 3 and 9.6)
Syllabus Outline
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Introduction to Macroeconomics
The measurement and structure of the national economy
Goods market equilibrium: the IS curve
Money market equilibrium: the LM curve
The IS-LM model
Demand-side policies in the IS-LM model (Keynesian
Macroeconomics)
The Aggregate Supply curve
Classical Macroeconomics in the AD-AS model
Keynesian Macroeconomics in the AD-AS model
The relationship between Unemployment and Inflation
Our goals in this chapter
A) Introduce the production function as the main determinant of
output
1. Discuss the marginal productivity of labor and capital
2. Analyze supply shocks
B) Discuss the determinants of labor demand and supply
C) Equilibrium in the classical model of the labor market
1. Full-employment output
2. Factors that change equilibrium
D) Unemployment
1. Definitions of employment status
2. Frictional, structural, cyclical unemployment
3. Okun’s Law
E) Aggregate Demand and Aggregate Supply
How Much Does the Economy
Produce? The Production Function
A) Factors of production
B) The production function
C) Application: The production function of the
U.S. economy and U.S. productivity growth
D) The shape of the production function
E) Supply shocks
How Much Does the Economy
Produce? The Production Function
A) Factors of production
1. Capital
2. Labor
3. Others (raw materials, land, energy)
4. Productivity of factors depends on technology and management
B) The production function
Y = A . F(K, N)
Y = real output produced in a given period of time
A = “total factor productivity” (TECHNOLOGY index, productivity in textbook)
K = capital stock, or quantity of capital used in the period
N = number of workers employed in the period
F = a function relating output Y to capital K and labor N
How Much Does the Economy
Produce? The Production Function
C) Application: The production function of the
U.S. economy and U.S. productivity growth
1. Cobb-Douglas production function works well for
U.S. economy:
Y = A K 0.3 N 0.7
2. Data for U.S. economy—Table 3.1
3. Technological growth calculated using production
function (percentage increase in A)
Table 3.1 The Production Function of the United States, 1980–2001
How Much Does the Economy
Produce? The Production Function
3. Technological growth calculated using production function:
a. Technology index , A, is measured indirectly by assigning to A
the value necessary to satisfy the previous equation
A = Y / (K 0.3 N 0.7)
b. Technology index, A, moves sharply from year to year
c. Technology index grew slowly in the 1980s and the first half of the
1990s, but increased in the second half of the 1990s
How Much Does the Economy
Produce? The Production Function
D) The shape of the production function
1. Two main properties of production functions
a. Slopes upward: more of any input produces more output
b. Slope becomes flatter as input rises: diminishing marginal
product as input increases
2. Graph of the production function
Figure 3.1 The production function relating output and capital
How Much Does the Economy
Produce? The Production Function
D) The shape of the production function
2. Graph of the production function
a. Marginal product of capital MPK = Y/K,
(1) Equal to slope of production function
graph (Y vs. K)
(2) MPK always positive
(3) Diminishing marginal productivity of
capital
Figure 3.2 The marginal product of capital
How Much Does the Economy
Produce? The Production Function
D) The shape of the production function
2. Graph of the production function
b. Marginal product of labor MPN = Y/N,
(1) Equal to slope of production function
graph (Y vs. N)
(2) MPN always positive
(3) Diminishing marginal productivity of
labor
Figure 3.3 The production function relating output and labor
How Much Does the Economy
Produce? The Production Function
E) Supply shocks
1. Supply shocks affect the amount of output that can be
produced for a given amount of inputs
2. Shocks may be positive (increasing output) or negative
(decreasing output)
3. Examples: weather, inventions and innovations, government
regulations, oil prices
4. Supply shocks shift graph of production function
How Much Does the Economy
Produce? The Production Function
E) Supply shocks
4. Supply shocks shift graph of production function
(1) Negative (adverse) shock: usually
slope of production function decreases at
each level of input (for example, if shock
causes parameter A to decline).
(2) Positive shock: usually slope of
production function increases at each
level of output (for example, if parameter
A increases).
Figure 3.4 An adverse supply shock that lowers the MPN
The Demand for Labor
A) How much labor do firms want to use?
B) The marginal product of labor and labor
demand: an example
C) The marginal product of labor and the labor
demand curve
D) Factors that shift the labor demand curve
E) Aggregate Labor Demand
The Demand for Labor
A) How much labor do firms want to use?
1. Assumptions
a. Hold capital stock fixed—short-run analysis
b. Workers are all alike
c. Labor market is competitive
d. Firms maximize profits
2. Analysis at the margin: costs and benefits of hiring
one extra worker
The Demand for Labor
A) How much labor do firms want to use?
2. Analysis at the margin: costs and benefits of hiring
one extra worker
a. If real (w)  marginal product of labor
(MPN), the firm is paying the marginal
worker more than the worker produces, so
the firm should reduce the number of
workers to increase profits.
b. If w  MPN, the marginal worker produces
more than he or she is being paid, so the
firm should increase the number of workers
to increase profits.
c. Firms’ profits are highest when w = MPN
The Demand for Labor
B) The marginal product of labor and labor demand: an
example
1. Example: The Clip Joint—setting the nominal wage equal to
the marginal revenue product of labor (MRPN = P  MPN)
2. W = MRPN is the same condition as w = MPN, since W = P 
w and MRPN = P  MPN
3. A change in the wage
a. Begin at equilibrium where W = MRPN
b. A rise in the wage rate means W  MRPN, unless N is
reduced so the MRPN rises
c. A decline in the wage rate means W  MRPN, unless N
rises so the MRPN falls
Table 3.2 The Clip Joint’s Production Function
The Demand for Labor
C) The marginal product of labor and the labor
demand curve
1. Labor demand curve shows relationship
between the real wage rate and the quantity of
labor demanded
2. It is the same as the MPN curve, since w =
MPN at equilibrium
3. So the labor demand curve is downward
sloping; firms want to hire less labor, the higher
the real wage
Figure 3.5 The determination of individual firm’s labor demand
The Demand for Labor
D) Factors that shift the individual firm’s labor
demand curve
1. Note: A change in the wage causes a
movement along the labor demand curve, not a
shift of the curve
2. Supply shocks: Beneficial supply shock raises
MPN, so shifts labor demand curve to the right;
opposite for adverse supply shock
3. Size of capital stock: Higher capital stock
raises MPN, so shifts labor demand curve to the
right; opposite for lower capital stock
Table 3.3 The Clip Joint’s Production Function After a Beneficial Productivity Shock
Figure 3.6 The effect of a beneficial supply shock on labor demand
The Demand for Labor
E) Aggregate Labor Demand
1. Aggregate labor demand is the sum of all firms’ labor
demand
2. Same factors (supply shocks, size of capital stock) that
shift firms’ labor demand cause shifts in aggregate labor
demand
The Supply for Labor
A) Supply of labor is determined by individuals
B) The income-leisure trade-off
C) Real wages and labor supply
D) The labor supply curve
E) Factors that shift the labor supply curve
F) Aggregate labor supply
G) Application: weekly hours of work and the
wealth of nations
The Supply for Labor
A) Supply of labor is determined by individuals
1. Aggregate supply of labor is sum of individuals’
labor supply
2. Labor supply of individuals depends on laborleisure choice
B) The income-leisure trade-off
1. Utility depends on consumption and leisure
2. Need to compare costs and benefits of working another
day
a. Costs: Loss of leisure time
b. Benefits: More consumption, since income is higher
3. If benefits of working another day exceed costs,
work another day
4. Keep working additional days until benefits equal costs
The Supply for Labor
C) Real wages and labor supply
1. An increase in the real wage has offsetting income and
substitution effects
a. Substitution effect of a higher real wage: Higher real wage
encourages work, since the reward for working is higher
b. Income effect of a higher real wage: Higher real wage
increases income for the same amount of work time, and with
higher income, the person can afford more leisure, so will
supply less labor
2. A pure substitution effect: a one-day rise in the real wage
A temporary real wage increase has just a pure substitution
effect, since the effect on wealth is negligible
The Supply for Labor
C) Real wages and labor supply
3. A pure income effect: winning the lottery
a. Winning the lottery doesn’t have a substitution effect, because
it doesn’t affect the reward for working
b. But winning the lottery makes a person wealthier, so a person
will both consume more goods and take more leisure; this is a
pure income effect
4. The substitution effect and the income effect together: a
long-term increase in the real wage
a. The reward to working is greater: a substitution effect toward
more work
b. But with a higher wage, a person doesn’t need to work as
much: an income effect toward less work
c. The longer the high wage is expected to last, the stronger the
income effect; thus labor supply will increase by less or
decrease by more than for a temporary reduction in the real
wage
The Supply for Labor
C) Real wages and labor supply
5. Empirical evidence on real wages and labor supply
a. Overall result: Labor supply increases with a temporary
rise in the real wage
b. Labor supply falls with a permanent increase in the
real wage
Equilibrium in the Labor Market:
The FE Line.
 Equilibrium in the labor market leads to employment
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at its full-employment level (Nbar) and output at its
full-employment level (Ybar)
If we plot output against the price level, we get a
vertical line, since labor market equilibrium is
unaffected by changes in the price level
This is the FE line
Also known as the LRAS line
If the economy is not producing at Ybar, eventually it
will return to this full-employment level of output
Factors that shift the FE/LRAS line
 The full-employment level of output is
determined by the full-employment level of
employment and the current levels of capital
(K) and technology (A).
 any change in these variables shifts the
FE/LRAS line