Aggregate Supply
CHAPTER
11
© 2003 South-Western/Thomson Learning
1
Aggregate Supply in 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
2
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, and
Household preferences for work versus
leisure
3
Labor and Aggregate Supply
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
However, the purchasing power of
any given nominal wage depends
on the economy’s price level
4
Labor and Aggregate Supply
The higher the price level, the less any
given money wage will purchase and
the lower the price level, the more any
given money wage will purchase
Because the price level matters, we
must distinguish between the nominal
wage and the real wage
Nominal wage measures the wage in
current dollars
Real wage measures the wage in constant
dollars  dollars measured by the goods
and services they will buy
5
Real and Nominal Wages
All resource suppliers, including labor,
must reach agreement based on the
expected price level
Wage agreements may be either explicit
or implicit
Explicit agreements would be those based
on a labor contract
Implicit agreements would be those based
on labor market practices
6
Potential Output
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
Potential output is the amount
produced when there are no surprises
associated with the price level
7
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
Natural rate of output
Full-employment rate of output
8
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
9
Actual Price Higher than Expected
Since the prices of many resources are
fixed for the duration of the contract,
firms welcome a price level 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
10
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
11
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
12
Why Costs Rise
However, 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
13
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
14
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
However, 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
15
Actual Price Lower than Expected
As a result, some workers are laid
off and capital resources go
unused
In this case, some costs decline
when output falls below the
economy’s potential
As output falls, some resources
become unemployed
16
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
17
Short-Run Aggregate Supply Curve
What what have just described can be
used to trace out the short-run
aggregate supply curve – SRAS
SRAS shows the relationship between
the actual price level and real GDP
supplied, other things constant
The short run is the period during which
some resource prices are fixed by either
explicit or implicit agreement
18
Exhibit 1:Short-Run Aggregate Supply Curve
Potential
output
SRAS 130
The expected price level is 130;
the SRAS is based on that
expected price level.
P ric e le vel
If the price level turns out to be
130 as expected, producers
supply the economy’s potential
level of output, $10.0 trillion.
140
130
a
120
0
10.0
Real GDP (trillions of dollars)
19
Exhibit 1: Short-Run Aggregate Supply Curve
Potential
output
SRAS 130
P ric e le ve l
140
130
a
120
0
The short-run
aggregate supply
becomes steeper
as output
increases because
resources become
more costly as
output increases
10.0 Real GDP (trillions of dollars)
20
Exhibit 2: Expansionary Gap
Potential
output
SRAS130
Price level
140
b
135
AD
130
a
0
10.0
10.2
Expansionary gap
Real GDP
(trillions of
dollars)
21
Exhibit 2: Expansionary Gap
Price level
Potential
output
SRAS 140
SRAS 130
c
140
b
135
AD
130
0
a
Real GDP
(trillions of dollars)
10.0
10.2
Expansionary gap
22
Exhibit 3: Contractionary Gap
Potential
output
SRAS130
Price level
130
a
125
d
e
120
AD
0
9.8
10.0
Contractionary gap
23
Exhibit 3: Contractionary Gap
Potential
output
SRAS130
SRAS120
Price level
130
a
125
d
e
120
AD
0
9.8
10.0
Contractionary gap
24
Contractionary Gap
The key to closing a contractionary gap
is the flexibility of wages and prices
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  the economy can be
stuck at an output and employment
level below its potential
25
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
26
Exhibit 4: Long-Run Aggregate Supply Curve
The initial price
level of 130 is
determined by the
intersection of AD
with the long-run
aggregate supply
curve.
Potential output
LRAS
140
b
130
a
120
c
AD'
AD
AD''
0
10.0
Real GDP (trillions of dollars)
27
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  they
tend to be sticky in the downward
direction
28
Wage Flexibility and Employment
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
29
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
30
Exhibit 6: Change in the Supply of Resources
LRAS
LRAS'
Price level
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'
0
10.0 10.5
Real GDP
(trillions of dollars)
31
Supply Shocks
Supply shocks are unexpected events
that change aggregate supply,
sometimes only temporarily
Beneficial supply shocks increase
aggregate supply; 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
32
Exhibit 7: Beneficial Supply Shock
Price level
LRAS LRAS'
SRAS 130
130
a
125
SRAS 125
b
AD
0
10.0
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.
10.2
Real GDP
(trillions of dollars)
33
Decreases in Aggregate Supply
Adverse supply shocks are 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
34
Exhibit 8: Adverse Supply Shock
LRAS'' LRAS
SRAS 135
Price level
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
SRAS 130
c
135
a
130
AD
0
9.8
10.0
Real GDP
(trillions of dollars)
35