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Aggregate Supply. Tells us how much is produced in goods and services in the country. Determinant of Aggregate Supply. Prices Wages and Prices of Other Inputs (raw materials) Capital stock State of Technology Expectations. Aggregate Supply.

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aggregate supply

Aggregate Supply

Tells us how much is produced in goods and services in the country.

determinant of aggregate supply
Determinant of Aggregate Supply
  • Prices
  • Wages and Prices of Other Inputs (raw materials)
  • Capital stock
  • State of Technology
  • Expectations
aggregate supply3

Aggregate Supply

Holding: Wages, Prices of Other Inputs Capital stock

State of Technology and

Expectations constant

Holding all other determinants of supply constant

Relationship between the price level and the Quantity of Real GDP supplied

aggregate supply4

Aggregate Supply

Shows the relationship between Prices and Output Supplied

important difference
Important Difference:
  • Price: what the producer sells output for. The price is paid by the ultimate user
  • Cost: what the producer pays for raw materials, labor and other expenses necessary to produce.

When costs rise, each unit is more expensive to produce, the producer must raise price to cover the increase in cost.

The change in costs occurs first

The change in price occurs as a result of the increase in cost.

wages are rigid sticky in the short run
Wages are rigid, “sticky” in the short run
  • Labor union contracts, wages change only when the contract expires.
  • Minimum wage laws
  • Workers do not accept lower wages easily.
  • Firms are reluctant to cut wages afraid to lose most productive workers and negatively affect productivity and morale.
  • Firms and workers know the recession will not last and thus “wait out” the bad times refusing to budge.
how do firms decide how much to produce
How do firms decide how much to produce?
  • Firms maximize profits
  • Profit per unit = Price per unit – Cost per unit.
  • Labor costs (wages and salaries) are “sticky” in the short run.
  • If labor is the ONLY cost of production then
  • When Prices increase, given that wages (costs) remain constant, profits increase: the firm reacts by producing moreunits
  • When Prices decrease, given that wages (costs) remain constant, profits decrease : the firm reacts by producing fewer units

If prices rise while wages and other costs are fixed, production becomes more profitable and firms produce more.

The Aggregate Supply Curve slopes upward in the short run: higher pricesresult in higher production

aggregate supply curves slopes upward
Aggregate Supply Curves Slopes Upward

Short Run Aggregate Supply= SRAS

Price Level

Real GDP supplied

movement along aggregate supply
Movement Along Aggregate Supply
  • When Prices increase, given that wages (costs) remain constant, profits increase and the firm will react by producing more units
  • When Prices decrease, given that wages (costs) remain constant, profits decrease and the firm will react by producing fewer units

Changes in Prices cause a movement along Aggregate Supply

shifts in the aggregate supply curve
Shiftsin the Aggregate Supply Curve
  • Prices
  • Wages and prices of Other Inputs
  • Capital stock: labor and Physical capital
  • Technology/Productivity

AS shifts to the left as firms produce less when their costs increase.

AS shifts to the right as firms produce more with a larger labor force or a larger stock of physical capital.

AS shifts to the right as firms produce more with better technology.

determining the price level

Determining the Price Level

The price level is the result of the interplay between Aggregate Demand and Aggregate Supply.

To determine the price level, we must put Aggregate Demand and Aggregate Supply together.

determining the price level12

120

100

80

Y

Y

AE

AE

Y=AE

Determining the Price Level

Price index

Excess Supply: AE < Y, inventories rise, firms decrease both production and prices

Aggregate Supply

AS

EQUILIBRIUM: AE = Y, inventories unchanged, firms do not change production or prices

Aggregate Demand

AD

Excess Demand: AE > Y, inventories drop, firms increase both production and prices.

6,400

5,600

6,000

0

Real GDP

slide13

If G, I, a, NX increase

AE line Shifts up

Equilibrium Income increases

Aggregate demand increases

45

Price level

AE1= C+I+G+NX

AE0= C+I+G+NX

Aggregate Expenditures

P0

AD1

AD0

Y0

Y1

Y0

Y1

Real GDP

Real GDP

the aggregate supply curve
The Aggregate Supply Curve

Potential GDP

Only Prices

rise

At Full Employment

Closer to Full Employment

Prices Increase

Prices do

Not change

Below full employment

Output Increases

Output can not increase

Output Increases

slide15

Smallest effect

Largest effect

For which segment does an increase in demand has the smallest/largest effect on output?

the self adjusting mechanism

The Self Adjusting Mechanism

How is it supposed to work?

adjusting to an inflationary gap
Adjusting to an Inflationary Gap

Economy’s self correcting mechanism to close an inflationary gap

Prices rise, inflationary gap closes: purchasing power of wealth decreases, AD decreases ( a movement up along AD)

AS2

Potential GDP

AS1

Labor market shortages: Difficult for firms to hire, easy for workers to win wage increases

P1

Inflationary Gap

100

Price level

Wages rise: AS shifts left as labor costs rise

AD0

5,000

4,000

Real GDP

adjusting to a recessionary gap

If wages and prices do not fall: self correcting mechanism operates only weakly to cure recessions

Adjusting to a Recessionary Gap

Unemployment: easy for firms to hire, difficult for workers to win wage increases

Potential GDP

AS1

Prices fall, gap closes: purchasing power increases, AD increases

AS2

Price level

100

Recessionary Gap

P1

AD0

Wages fall: AS shifts right as labor costs decrease

5,000

6,000

Real GDP

the effect of an increase in demand
The effect of an Increase in Demand

1. Economy starts at Potential GDP

2. Inflationary gap appears

3. Prices rise, output drops back to Potential GDP

Economy ends at Potential GDP

SRAS2

AS2

Potential GDP = LRAS

Potential GDP

AS1

In the Short Run AS has a positive slope

In the Long Run AS is Vertical at Potential GDP

3

AS shifts left as labor costs rise

P2

Inflationary Gap

2

AD increases

P1

In the long run (ignoring the temporary move to point 2) the economy always ends up at potential GDP

P0

Price level

1

AD1

AD0

5,000

4,000

Real GDP

does the us economy has a self correcting mechanism
Does the US economy has a self correcting mechanism?

YES

  • When the economy experiences an inflationary gap, wages increase, shifting the AS left, increasing prices and thus slowing down AD.
  • When the economy experiences a recessionary gap, wages decrease, shifting the AS right, decreasing prices and thus increasing AD.

BUT

  • This mechanism works slowly so there is an argument to be made in favor of stabilization policies.
using the model

Using the Model

Stagflation from a Supply Shock: Rising Energy Prices shift the AS left

stagflation from a supply shock
Stagflation from a Supply Shock

AS2

AS1

Higher prices & lower output: stagflation

P1

100

Oil Prices rise: AS shifts left

Price level

AD0

5,000

Real GDP

slide23

Determinants of consumption

  • Changes in wealth
    • shift the consumption function.
    • Example: value of stocks, bonds, consumer durables.
  • Changes in consumer expectations
    • Shift the consumption function.
    • Example: Pessimistic expectations decrease autonomous consumption.
  • Prices
    • Affect the purchasing power of assets.

Shift up in AE line

Shift right in AD line

Shift up in AE line

Movement Along AD line

slide24

Determinants of Investment

  • Interest Rates:
  • Tax Incentives:
  • Technical Change:
  • Expectations about the strength of demand:
  • Political Stability and the rule of law:

Shift AE line

Shift AD line

government expenditures are determined by the budget process the president congress and the senate
Government expenditures are determined by the budget process: The president, Congress and the Senate.

Government expenditures

Shift AE line

Shift AD line

Fiscal Policy

slide26

Determinants of Net Exports

  • National Incomes
  • GDP of other countries
  • Relative Prices
  • Exchange Rates

Shift AE line

Shift AD line

shifts in the aggregate supply curve27
Shifts in the Aggregate Supply Curve
  • Prices
  • Wages and prices of Other Inputs
  • Capital stock: labor and Physical capital
  • Technology/Productivity

AS shifts to the left as firms produce less when their costs increase.

AS shifts to the right as firms produce more with a larger labor force or a larger stock of physical capital.

AS shifts to the right as firms produce more with better technology.

which graph describes the effect of an increase in autonomous consumption
Which graph describes the effect of an increase in Autonomous Consumption

Near Full employment

Below Full Employment

Near Full employment

Below Full Employment

slide29

Increased oil prices

  • Increase in autonomous consumption
  • Adverse supply shock with increase in government spending
  • Rising wage rates
  • Increase in labor productivity

B

A

D

C

E

Which graph best describes the effect of the following events

slide30

2. Recession caused by a decrease in consumption and increase in productivity

3. Recession & deflation mainly caused by drop in AD

2

3

5

4.Expansion with inflation caused mainly by increase in AD

Which graph best describes the effect of the following events

  • Economic growth and inflation

5.Expansion with deflation mainly caused by increase in AS

1

4

5

questions to prepare for the quiz
Questions to prepare for the Quiz

Draw both an AE – 45degree line and an AS-AD diagram to show the effect on GDP and the price level resulting from the following events:

  • A Decrease in interest rates.
  • Oil prices drop (a drop in costs of production).
  • Pessimistic business forecasts lead businesses to reduce their planned investment.
questions to prepare for the quiz32
Questions to prepare for the quiz
  • A tax cut on business.
  • Increase in government spending.
  • A major increase in home prices
  • U.S pulls troops out of Iraq.
  • Manufacturers rush to acquire the new technology for producing zero emissions cars.
  • Overall prices increase (CPI increases)
  • Europeans impose tariffs on imported goods
  • U.S. retaliates by imposing tariffs on European goods
slide34

If G, I, a, NX increase

AE line Shifts up

Equilibrium Income increases

45

Price level

AE1= C+I+G+NX

DY = DG (1/1-MPC)

AE0= C+I+G+NX

Aggregate Expenditures

P0

AD1

DY = DG (1/1-MPC)

AD0

Y0

Y1

Y0

Y1

Real GDP

Real GDP

inflation reduces the size of the multiplier
Inflation Reduces the Size of the Multiplier

AD Shifts by the full multiplier amount

DY = DG (1/1-MPC)

If firms DO NOT raise prices

AS1

Excess Demand: AE > Y, inventories drop, firms increase both production and prices.

P1

P0

Price level

AD1

If firms DO raise prices, the increase in output is SMALLER than given by the multiplier formula

AD0

Y0

Y1

Y2

Real GDP

the aggregate supply curve36
The Aggregate Supply Curve

Only Prices

rise

At Full Employment

Closer to Full Employment

Prices Increase

Prices do

Not change

Below full employment

Output can not increase no multiplier effect

Output Increases by less than multiplier

Output Increases by full multiplier

slide37

Smallest multiplier effect

Largest multiplier effect

Which segment has the smallest/largest multiplier effect?

slide38

a. Decrease in interest rates d. a tax cut on purchase of equipment g. rush to acquire new technology:

increases Investment, AE, Equilibrium Output, AD, Prices and GDP.

AS0

AE1

P1

AE0

P0

AD1

AD0

Y0

GDP0

GDP1

Y1

slide39

c. Pessimistic forecast: Decreases Investment, AE, Equilibrium Output, AD, Prices and GDP.

AS0

AE0

AE1

P0

P1

AD1

AD0

Y1

Y0

GDP1

GDP0

slide40

e. Increase in home prices: increases real value of wealth , consumption, AE, Equilibrium Output, AD, Prices and GDP.

AS0

AE1

P1

AE0

P0

AD1

AD0

Y0

GDP0

GDP1

Y1

slide41

e.Overall Prices Decrease: increases wealth (in real terms), increase in Consumption, AE, Equilibrium Output, movement along AD

AS0

AE1

AE0

P0

P1

AD1

AD0

Y0

GDP0

GDP1

Y1

slide42

f. U.S. pulls troops out of Iraq: Decreases Government Spending, AE, Equilibrium Output, AD, Prices and GDP.

AS0

AE0

AE1

P0

P1

AD1

AD0

Y1

Y0

GDP1

GDP0

slide43

e. U.S. imposes tariffs on European goods: Decreases Imports, increases net exports, AE, Equilibrium Output, AD, Prices and GDP.

AS0

AE1

P1

AE0

P0

AD1

AD0

Y0

GDP0

GDP1

Y1

slide44

i. Europeans impose tariffs on imported goods: Decreases Exports, AE, Equilibrium Output, AD, Prices and GDP.

AS0

AE0

AE1

P0

P1

AD1

AD0

Y1

Y0

GDP1

GDP0

slide46

A favorable supply shock (drop in cost of production or increase in productivity): wages drop, oil prices drop

AS0

AS1

P0

P1

AD0

GDP0

GDP1