Great introduction to as curve

Aggregate SupplyAggregate supply is the relationship between the price

level in the economy and the quantity of aggregate output firms are willing and able to supply, other things held constant

The foundation of aggregate supply is the labor market Like any market, the labor market has a demand side and a

supply side A good understanding of aggregate supply requires a

correct understanding of the demand and supply sides of the labor market

The Aggregate Supply Curve:A Warning

The aggregate supply curve is not a market supply curve or the sum of all the individual supply curves in the economy.

The Aggregate Supply (AS) curve is an important tool in analysing the macroeconomy. Its shape describes whether and by how much an economy can increase output.

The curve is built from and affected by some of the main macroeconomic building blocks such as wages, labour and prices and production function.

The curve can be used to analyses the effect of changes in these on the economy as a whole, and to examine the impact of shocks such as oil shocks. Both long and short run effects need to be considered.

A detailed understanding is required to understand the shape of AS CURVE

The Aggregate Supply curve is derived ultimately from the short run aggregate production function. A production function is a mathematical relationship between inputs and outputs. At the macroeconomic level, the aggregate production function shows the relationship between Gross Domestic Product, GDP (Y), and various macroeconomic inputs. The most important of these are the hours of labour employed (N) and the units of capital employed (K), all though others such as the price of oil or technology may be relevant if these change. This then gives a production function:

Y = f(N,K)

where f is the aggregate production function. Note that Y always increases if one of the inputs increases (monotonically increasing). Increasing all units by an equal proportion (e.g. doubling) will increase Y by the same proportion (constant returns to scale), but the curve will exhibit diminishing marginal returns.

Assuming Capital is constant

Y= F(N) National Y increases

with increase in NBut at a diminishing

rateDemand Theory

states that Entrepreneurs employ till

MPL*P=WW/P= MPL

In capitalist economies, firms will only employ the labour (and other inputs) that they need to. This makes the demand for labour, the Marginal Productivity of Labour (MPL), a derived

demand.

This function can be worked out from the slope of the short run aggregate production function. Mathematically speaking, MPL is

the first derivative, δf/δN, of Y=f(N,K¯),

where w is nominal wages, p is the price level and w/p is real wages. This is shifted by the same factors as Y=f(N,K¯), such as improvements in technology or increase in capital.

In the short run, we can consider K to be fixed ( ). The short run aggregate production function is then Y=f(N, ),

Varying N will cause a move along the curve, whilst varying K (or any other input) will shift the curve up or down.

Y=f(N, )wpMPLIn capitalist economies, firms will only employ the labour

(and other inputs) that they need to. This makes the demand for labour, the Marginal Productivity of Labour (MPL), a derived demand.  

This function can be worked out from the slope of the short run aggregate production function. Mathematically speaking, MPL is the first derivative, δf/δN, of Y=f(N,K¯),

where w is nominal wages, p is the price level and w/p is real wages. This is shifted by the same factors as Y=f(N,K¯), such as improvements in technology or increase in capital.

The Nominal Wage and the Real WageThe nominal wage is the wage measured in

terms of current dollarsThe real wage is the wage measured in terms

of dollars of constant purchasing powerThe real wage is the wage measured in terms of the

quantity of goods it will purchase

Both workers and employers care more about the real wage than the nominal wage

Wages and Price Level Expectations

Nominal wages are important because resource agreements (such as wage contracts) are typically negotiated in nominal wages

Since wage contracts are negotiated ahead of time, they are based on workers’ expectation for the price level

Y=f(N,K )Y

NN

w0p0

MPL

N0 N1

w1p1

N0 N1

Labor Supply The supply of labor

depends primarily on the wage rate (the dollar cost of a unit of labor, such as an hour of work)

The supply of labor also depends on The size of the adult

population The skills (productivity)

of the adult population Households’ preferences

for work versus leisure N0N1

w0p0

w1p1

The labour market is in equilibrium where the two lines intersect. To the left, the demand for labour exceeds the supply. Wages will eventually rise to restore equilibrium. To the right, the supply exceeds demand and there is unemployment.

Factors that may shift the supply of labour include income tax, motivation to work, unemployment benefit and the value of leisure time.

N

N

W/P

W/P

Y

Output(Y)

Price AS

Potential Output and the Natural Rate of Unemployment

Potential output is the economy’s maximum sustainable output level, given the supply of resources, technology, and the underlying economic institutions.

Another point of view is the that potential output is the level of output where there are no “surprises” about the price level.

The natural rate of unemployment is the rate that occurs when the economy is producing it potential level of output

Aggregate Supply in the Short RunMacroeconomists focus on whether or not

the economy as a whole is operating at full capacity.

As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices.

Hence The Classical Aggregate supply curve is a vertical line

In long run when all resources are completely employed then firms respond to increase in demand by raising prices

The Aggregate Supply Curve:A Warning

When we draw a firm’s supply curve, we assume that input prices are constant. In macroeconomics, an increase in the overall price level means that at least some input prices will be rising as well.

The outputs of some firms are the inputs of other firms.

The Aggregate Supply Curve:A Warning

Rather than an aggregate supply curve, what does exist is a “price/output response” curve — a curve that traces out the price and output decisions of all the markets and firms in the economy under a given set of circumstances.

Keynesian Aggregate supply Model

Keynes assumed that input prices in short run are not flexible ,

At less than full employment level increase in AD leads to rise in output without increase in wages or input prices

AS

Y

P

The Short RunThe short run is a

period during which some resources prices, especially labor, are fixed by agreement

The Short-Run Supply Curve If the price level is higher

than expected, the quantity supplied is above the economy’s potential output If the price level is lower

than expected, the quantity supplied decreases

As a result, there is a positive short-run relationship between the price level and aggregate output supplied

Real GDP

Price LevelSRAS

Aggregate Supply in the Short RunAt low levels of

aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical.

The Sticky Wage ModelMany economists believe that

nominal wages are sticky in the short run.

( )eY Y P P

L0L

W/P

DL

When the nominal wage is stuck, a rise in P from P0 to P1 lowers the real wage, making

labour cheaper.

W/P0

W/P1

L1

The lower real wage induces firms to hire

more labour.The additional labour hired produces more

output.The positive

relationship between P and Y means AS slopes

upward.

L0L

Y=F(L)Y1

Y0

L1

Y

Y1Y

P1

P0

Y0

P

Output Levels andPrice/Output ResponsesWhen the economy is operating at low levels

of output, an increase in aggregate demand is likely to result in an increase in output with no increase in the overall price level. (Keynesian AS Curve )

The Response of Input Prices to Changes in the Overall Price Level

There must be a lag between changes in input prices and changes in output prices, otherwise the aggregate supply (price/output response) curve would be vertical.

The Long-RunAggregate Supply Curve

Costs lag behind price-level changes in the short run, resulting in an upward-sloping AS curve.

• Costs and the price level move in tandem in the long run, and the AS curve is vertical.

Shifts of the Short-RunAggregate Supply Curve

A cost shock, or supply shock, is a change in costs that shifts the aggregate supply (AS) curve.

Bad weather, natural disasters, destruction from wars

Good weather

Public policy waste and inefficiency over-regulation

Public policy supply-side policies tax cuts deregulation

Stagnation capital deterioration

Economic growth more capital more labor technological change

Higher costs higher input prices higher wage rates

Lower costs lower input prices lower wage rates

Shifts to the LeftDecreases in Aggregate Supply

Shifts to the RightIncreases in Aggregate Supply

Factors That Shift the Aggregate Supply Curve

The Long-RunAggregate Supply Curve

Output can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises.

The Long-RunAggregate Supply Curve

When output is pushed above potential, there is upward pressure on costs, and this causes the short-run AS curve to the left.

• Costs ultimately increase by the same percentage as the price level, and the quantity supplied ends up back at Y0.

The Long-RunAggregate Supply Curve

Y0 represents the level of output that can be sustained in the long run without inflation. It is also called potential output or potential GDP.

Aggregate Demand, AggregateSupply, and Monetary and Fiscal Policy

Expansionary policy works well when the economy is on the flat portion of the AS curve, causing little change in P relative to the output increase.

• AD can shift to the right for a number of reasons, including an increase in the money supply, a tax cut, or an increase in government spending.

Aggregate Demand, AggregateSupply, and Monetary and Fiscal Policy

When the economy is operating near full capacity, an increase in AD will result in an increase in the price level with little increase in output.

• On the steep portion of the AS curve, expansionary policy does not work well. The multiplier is close to zero.

Long-Run AggregateSupply and Policy Effects

If the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output.

• In the long run, the multiplier effect of a change in government spending or taxes on aggregate output is zero.

The Simple “Keynesian”Aggregate Supply Curve

The output of the economy cannot exceed the maximum output of YF.

The difference between planned aggregate expenditure and aggregate output at full capacity is sometimes referred to as an inflationary gap.

Causes of InflationInflation is an increase in

the overall price level.Sustained inflation occurs

when the overall price level continues to rise over some fairly long period of time.

Causes of InflationDemand-pull inflation

is inflation initiated by an increase in aggregate demand.

• Cost-push, or supply-side, inflation is inflation caused by an increase in costs.

Cost-Push, or Supply-Side Inflation• Stagflation occurs

when output is falling at the same time that prices are rising.

• One possible cause of stagflation is an increase in costs.

Cost-Push, or Supply-Side InflationCost shocks are bad

news for policy makers. The only way to counter the output loss is by having the price level increase even more than it would without the policy action.

Expectations and InflationIf every firm expects every other firm to

raise prices by 10%, every firm will raise prices by about 10%. This is how expectations can get “built into the system.”

• In terms of the AD/AS diagram, an increase in inflationary expectations shifts the AS curve to the left.

Money and InflationHyperinflation is a

period of very rapid increases in the price level.

Money and Inflation• An increase in G with

the money supply constant shifts the AD curve from AD0 to AD1. This leads to an increase in the interest rate and crowding out of planned investment.

Money and Inflation• If the Fed tries to prevent

crowding, it will increase the money supply and the AD curve will shift farther and farther to the right. The result is a sustained inflation, perhaps hyperinflation.