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Chapter 26
Aggregate Supply
© 2006 Thomson/South-Western
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Aggregate Supply in the 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
Household preferences for work versus leisure
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
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Labor and Aggregate Supply
The higher the price level, the less any
given money wage will purchase
The lower the price level, the more any
given money wage will purchase
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Real and Nominal Wages
Real wage: the wage measured in current
dollars; the dollar amount on a paycheck
Nominal wage: the wage measured in
dollars of constant purchasing power; the
wage measured in terms of the quantity
of goods and services it will buy
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Real and Nominal Wages
Workers and employers care more about the
real wage than about the nominal wage
It is uncertain 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 long-term
contracts remain in force for extended periods
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Real and Nominal Wages
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 are based on a labor
contract
Implicit agreements are based on labor
market practices
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Potential Output
Potential output: The economy’s maximum
sustainable output, given the supply of resources,
technology, and production incentives; the
output level when there are no surprises about
the price level
 Firms
and resource suppliers expect a certain price
level to prevail in the economy during the year
 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
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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 such as
the natural rate of output or the fullemployment rate of output
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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
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Actual Price Higher than Expected
The short run is a period during which many
resource prices remain fixed by contract
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
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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Short-Run Period
Short run: a period during which some
resource prices, especially those for labor,
are fixed by explicit or implicit
agreements
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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
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
Workers might be willing to increase the
quantity of labor they supply is that the labor
agreement might require this
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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
 Production is less attractive to firms because the
prices they receive for their output are on average
lower than they expected





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
some workers are laid off and capital resources go unused
some costs decline when output falls below the economy’s
potential
 As output falls, some resources become unemployed
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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
there is a direct relationship in the short run
between actual price level and real GDP
supplied
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Exhibit 1:Short-Run Aggregate Supply Curve
SRAS130
140
Price level
The short run aggregate
supply curve, SRAS, shows the
relationship between the
actual price level and real
GDP supplied, other things
constant
If the price level turns out to
be 130 as expected, producers
supply the economy’s potential
level of output, $12.0 trillion
If the economy produces at
its potential, unemployment is
at the natural rate.
Output levels that fall short
of the economy’s potential are
shaded red; output levels that
exceed the economy’s potential
are shaded blue.
Potential
output
130
a
120
0
12.0
Real GDP (trillions of dollars)
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From the Short Run to the Long Run
Short-run equilibrium: the price level and
real GDP that occur when the aggregate
demand curve intersects the short-run
aggregate supply curve
Expansionary gap: The amount by which
output in the short run exceeds the
economy's potential output
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Long Run
In macroeconomics, a period during which
wage contracts and resource price agreements
can be renegotiated; there are no surprises
about the economy’s actual price level
Long-run equilibrium: The price level and real
GDP that occurs when (1) the actual price level
equals the expected price level, (2) real GDP
supplied equals potential output, and (3) real
GDP supplied equals real GDP demanded
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Exhibit 2: Short-Run Equilibrium When the Price
Level Exceeds Expectations
Potential
output
SRAS 140
140
Price level
The equilibrium price level
and real GDP depend on
aggregate demand
What if aggregate demand
turns out to be greater than
expected, as shown by AD
Point b is the short-run
equilibrium, reflecting a price
level of 135 and a real GDP of
$12.2 trillion
The actual price level is
higher than expected and the
level of output exceeds the
economy’s potential
The amount by which shortrun equilibrium output
exceeds the economy’s
potential is often referred to as
the expansionary gap
SRAS 130
c
b
135
AD
130
a
0
12.0
12.2
Real GDP
(trillions of dollars)
Expansionary gap
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Exhibit 2: Short-Run Equilibrium When
the Price Level Exceeds Expectations
Potential
output
SRAS 140
140
Price level
When real GDP exceeds
potential output, actual
unemployment rate is below its
natural rate.
Because the price level
prevailing in the short run
exceeds the expected price
level, the real wage is lower
than expected
What happens in the long
run?
Nominal wages increase,
firms’ production costs
increase, and the short-run
aggregate 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
SRAS 130
c
b
135
AD
130
a
0
12.0
12.2
Expansionary gap
Real GDP
(trillions of dollars)
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Contractionary Gap
Contractionary gap: the amount by
which actual output in the short run falls
short of the economy’s potential output
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
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Exhibit 3: Short-Run Equilibrium When the Price
Level is Below Expectations
SRAS130
130
Price level
Again, begin with an expected
price level of 130.
If the AD curve intersects the
short-run AS curve to the left of
potential output (at point d),
production is less than the
economy’s potential
Amount by which actual
output falls short of potential
GDP is called the
contractionary gap
Unemployment exceeds the
natural rate
The lower-than-expected
price level translates into a
higher real wage in the short
run
Potential
output
a
d
125
e
120
AD
0
11.8
12.0
Contractionary gap
Real GDP
(trillions of dollars)
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Exhibit 3: Short-Run Equilibrium When the Price
Level is Below Expectations
SRAS130
SRAS120
Price level
What happens in the long run?
Employers are no longer
willing to pay as high a nominal
wage; 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
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 longrun equilibrium at point e
Potential
output
130
125
a
d
e
120
AD
0
11.8
12.0
Contractionary gap
Real GDP
(trillions of dollars)
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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
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Exhibit 4: Long-Run Aggregate Supply Curve
A decline aggregate
demand from AD to
AD'' will, in the long
run, lead to a fall in
the price level with no
change in output
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
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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
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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
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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
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Exhibit 5: U.S. Output Gaps Measures Actual Output Minus
Potential Output as Percentage of Potential Output
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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
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Exhibit 6: Effect of a Gradual Increase in
Resources on Aggregate Supply
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'
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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
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Exhibit 7: Effects of a Beneficial Supply Shock
on Aggregate Supply
LRAS
LRAS'
Price level
SRAS130
a
130
125
SRAS125
b
AD
0
12.0
12.2
Real GDP
(trillions of dollars)
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
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Decreases in Aggregate Supply
Adverse supply shocks: 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
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Exhibit 8: Effects of an Adverse Supply Shock
on Aggregate Supply
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
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