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Aggregate Supply

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© 2003 South-Western/Thomson Learning

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Aggregate Supply in Short RunAggregate 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 pricesState of technologySet of formal and informal institutions that structure production incentives

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Labor and Aggregate SupplyLabor 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, andHousehold preferences for work versus leisure

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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

Things get a bit more complicated when we recognize that the purchasing power of any given nominal wage depends on the economy’s price level

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Labor and Aggregate SupplyThe 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 dollarsReal wage measures the wage in constant dollars dollars measured by the goods and services they will buy

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Real and Nominal WagesWorkers and employers care more about the real wage than about the nominal wage

The problem is that nobody knows for sure 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 WagesThus, 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 would be those based on a labor contractImplicit agreements would be those based on labor market practices

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Potential Output

Firms and resource suppliers expect a certain price level to prevail in the economy during the year

This price level can be regarded as resulting from the consensus view of inflation for the upcoming year

Based on these consensus expectations, firms and resources suppliers reach agreement on resource prices, such as wages

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Potential OutputIf 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 levelTherefore, workers are supplying the quantity of labor they want to and firms are hiring the quantity of labor they want to

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Potential Output

Potential output can be thought of as the economy’s maximum sustainable output level, given the

Supply of resourcesState of technologyFormal and informal production incentives

Often referred to by other termsNatural rate of outputFull-employment rate of output

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Natural Rate of UnemploymentNatural rate of unemployment

The unemployment rate that occurs when the economy is producing its potential GDPThe rate that prevails when cyclical unemployment is zeroThe number of job openings is equal to the number unemployed for frictional, structural, and seasonal reasonsEstimates of the natural rate range from about 4 to 6% of the labor force

Summary: when the actual price level turns out as anticipated, the expectations of both workers and firms are fulfilled economy produces its potential

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Actual Price Higher than Expected

What if the economy’s price level turns out to be higher than expected?

What happens in the short run to aggregate output supplied?

The short run is a period during which many resource prices remain fixed by contract

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Actual Price Higher than Expected

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

While it may appear contradictory to talk about producing beyond the economy’s potential, remember that potential output does not mean zero unemployment

Rather, it means that the actual unemployment rate equals the natural rate of unemployment approximately 96% of the labor force working

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Actual Price Higher than ExpectedThat is, 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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Why Costs RiseAs output expands above potential GDP, the cost of producing this additional output increases

Additional workers are harder to findSome workers may not be properly preparedThe prices of those resources purchased in markets where prices are flexible will increase reflecting their increased scarcityFirms use their capital resources more intensively

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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

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Why Costs Rise

Why might workers be willing to increase the quantity of labor they supply when the price level is higher than expected?

One possible reason is that the labor agreement might require workers to offer their labor at the agreed upon nominal wage

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SummaryIf 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

What happens if the price level turns out to be lower than expected?Production is less attractive to firms because the prices they receive for their output are on average lower than they expectedHowever, 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

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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 the prices of resources decline in markets where the price is flexible and firms can become more selective about which resources to retain

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SummaryIf the price level is higher than expected

Firms increase the quantity supplied beyond the economy’s potentialThe per-unit cost of additional production increases

If the price level is lower than expectedFirms reduce output below the economy’s potential outputPrices fall more than costs

The combination of these two changes implies that there is a direct relationship in the short run between the actual price level and real GDP supplied

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Short-Run Aggregate Supply CurveWhat 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

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Short-Run Aggregate Supply Curve

If the economy produces its potential output, unemployment is at the natural rate

Thus, there is not tendency to move away from point a even if workers and firms have a chance to renegotiate their contracts

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From the Short Run to the Long Run

Here we begin with a short-run equilibrium that is higher than expected to see what happens in the long run

The long run is long enough so that firms and resource suppliers are able to renegotiate all agreements based on knowledge of the actual price level there are no surprises about the price level

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Long-Run EquilibriumConsider all the equalities that hold in long-term equilibrium

The actual price level equals the expected price levelThe quantity supplied in the short run equals potential output, which also equals the quantity supplied in the long runThe quantity supplied equals the quantity demanded

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Long-Run EquilibriumThe long-run equilibrium attained at point c is no different in real terms from what had been expected at point a

At both pointsFirms are willing and able to supply the economy’s potential level of outputThe same amounts of labor and other resources are employedThe real wage and real return to other resources are the same even though nominal wages and payments are higher

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Contractionary GapThe 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

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Long-Run Aggregate SupplyThe long-run aggregate supply curve, LRAS, depends on the

supply of resources in the economylevel of technologyproduction 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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Wage Flexibility and EmploymentWhat 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 they tend to be sticky in the downward direction

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Wage Flexibility and EmploymentSince 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 wageThe real wage will fall as long as the price level increases more than the nominal wage

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Changes in Aggregate SupplyWe now consider factors other than changes in the expected price level that may affect aggregate supply

In doing this, we must distinguish between

long-term trends in aggregate supply, andsupply shocks, which are unexpected events that affect aggregate supply, often only temporary

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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 technologyinstitutional underpinnings of the economic system

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Supply ShocksSupply 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 foodDiscoveries of natural resourcesTechnological breakthroughs that allow firms to combine resources more efficientlySudden changes in the economic system that promote more production

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Decreases in Aggregate SupplyAdverse supply shocks are sudden, unexpected events that reduce aggregate supply, again sometimes, only temporarily

Drought could reduce the supply of a variety of resourcesGovernment instabilityTerrorist attacks