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Understanding Aggregate Supply Curve: Impacts on Economy

Learn how changes in Aggregate Supply (AS) impact price levels, production, and overall economy. Explore why the AS curve slopes upward and how shifts affect equilibrium GDP and price levels.

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Understanding Aggregate Supply Curve: Impacts on Economy

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  1. Chapter 10 Bringing in the Supply Side: Unemployment and Inflation? We might as well reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by [demand] or [supply]. ALFRED MARSHALL

  2. Why AS? Chapter 9 tells us change in AD will create inflationary gap vs. recessionary gap Which sort of gap will arise? Need to know price level AS + AD determine price level This chapter: bring the supply side back

  3. The Aggregate Supply Curve • Aggregate supply curve • Each possible price level • Quantity of goods & services • All nation’s businesses - willing to produce • Specified period of time • All other determinants – constant • Aggregate supply curve • Slopes upward

  4. Figure 1 An aggregate supply curve S Price Level S Real GDP

  5. The AS Curve: Why Upward Slope? • Unit profit = Price – Unit cost • Aggregate supply curve - slopes upward • Firms – purchase inputs • Prices – fixed for some period of time • Higher selling prices – output • Production – more attractive • Aggregate supply curve • Shifts outward/right • More output produced • Any given price level

  6. The Aggregate Supply Curve • Aggregate supply curve • Nominal wage rate – increase • Higher real production costs • Aggregate supply curve – shifts inward/left • Prices of other inputs – increase • Higher real production costs • Aggregate supply curve – shifts inward/left

  7. Figure 2 A shift of the aggregate supply curve B S0 (lower wages) A 100 S1 (higher wages) Price Level (P) S0 S1 0 5,500 6,000 Real GDP (Y)

  8. The Aggregate Supply Curve • Aggregate supply curve • Technology & productivity – improve • Decrease business costs • Aggregate supply curve – shift outward/right • Available supply of labor & capital – better • Labor force - grows or improves in quality • Capital stock – increases (investment) • Aggregate supply curve – shifts outward/right

  9. Equilibrium: Aggregate Demand & Supply • Equilibrium GDP • AD curve intersects AS curve • Equilibrium price level • Equilibrium quantity

  10. Figure 3 Equilibrium of real GDP and the price level S D 130 E 120 110 Price Level (P) 100 90 80 D S 0 5,200 5,600 6,000 6,400 6,800 Real GDP (Y)

  11. Equilibrium: Aggregate Demand & Supply • For price level > Equilibrium price level • Aggregate quantity supplied exceeds • Aggregate quantity demanded • Inventories – increase • Prices – forced down • Price level – falls • Production – falls

  12. Equilibrium: Aggregate Demand & Supply • For price level < Equilibrium price level • Aggregate quantity demanded exceeds • Aggregate quantity supplied • Shortage of goods • Inventories – decrease • Prices – increase • Price level – rise • Production – rise

  13. Table 1 Determination of the equilibrium price level

  14. Inflation and the Multiplier • Aggregate supply curve – slopes upward • Any increase in aggregate demand • Price level – increase • Erodes purchasing power of consumer wealth • Reduces net exports • Inflation – reduces value of multiplier

  15. Figure 4 Inflation and the multiplier S D1 D0 130 E1 A E0 120 110 Price Level (P) 100 $800 billion 90 80 D0 D1 S 0 6,000 6,400 6,800 Real GDP (Y)

  16. Recessionary & Inflationary Gaps • Recessionary gap • Equilibrium GDP < Potential GDP • Aggregate demand – weak • Inflationary gap • Equilibrium GDP > Potential GDP • Excess aggregate demand

  17. Figure 5 (a) Recessionary and inflationary gaps revisited E E B B Potential GDP 45° S C+I0+G+(X-IM) Recessionary gap Potential GDP Recessionary gap Real Expenditure Price Level D0 D0 S Real GDP Real GDP 0 7,000 7,000 6,000 6,000

  18. Figure 5 (b) Recessionary and inflationary gaps revisited E E Potential GDP 45° S C+I1+G+(X-IM) Potential GDP Real Expenditure Price Level D1 D1 S Real GDP Real GDP 0 7,000 7,000

  19. Figure 5 (c) Recessionary and inflationary gaps revisited Inflationary gap E B B Inflationary gap C+I2+G+(X-IM) Potential GDP E 45° S Potential GDP Real Expenditure Price Level D2 D2 S Real GDP Real GDP 0 7,000 7,000 8,000 8,000

  20. Adjusting to a Recessionary Gap • Recessionary gap  cyclical unemployment   wage   AS curve shifts outward  Y, P • It is a self-correcting mechanism

  21. Figure 6 The elimination of a recessionary gap Potential GDP S1 S0 E B F D Recessionary gap Price Level (P) 100 D S0 S1 6,000 5,000 Real GDP (Y)

  22. Adjusting to a Recessionary Gap • In reality, wages & prices rarely fall • Institutional factors: minimum wage law, union contracts • Psychological resistance to wage reduction • Business cycles – less severe • Firms – don’t want to lose best employees • Economy - get stuck • Recessionary gap - long period

  23. Adjusting to Inflationary Gap: Inflation • Inflationary gap  over employment  wage   AS shifts inward  Y, P • Again, it is a self-correcting mechanism

  24. Figure 7 The elimination of an inflationary gap Potential GDP S0 S1 F E B D Inflationary gap Price Level (P) D S0 S1 Real GDP (Y)

  25. Adjusting to Inflationary Gap: Inflation • Self-correcting mechanism • Takes time • Stagflation • Inflation and economic stagnation • Normal – after excessive aggregate demand

  26. Stagflation from a Supply Shock • Higher energy prices • Aggregate supply – shift inward • “Oil shocks” • Adverse supply shocks • Inward shift of aggregate supply • Falling production • Rising prices

  27. Figure 8 Stagflation from an adverse shift in aggregate supply S0 S1 A E 36.0 D 31.8 Price Level (2000=100) D S0 S1 4,342 4,275 Real GDP

  28. Applying Model to a Growing Economy • Simple model • Aggregate demand • Aggregate supply • Equilibrium price level • Equilibrium level of real GDP • U.S. : price level & real GDP, 1972-2007 • Higher price level • Higher GDP • Growth & Inflation

  29. Figure 9 The price level & real GDP output in U.S., 1972–2007

  30. Applying Model to a Growing Economy • Every year • Aggregate demand – grows • Shift right • Growing population • More demand: consumer & investment goods • Increased government purchases • Aggregate supply – shift right • More workers • Investment & technology • Improve productivity

  31. Figure 10 S0 S1 Aggregate supply & demand analysis: growing economy A B 116.5 Price Level (P) (2000=100) 113 D1 D0 D0 D1 S1 S0 11,000 11,330 Real GDP (Y) in Billions of 2000 Dollars

  32. Applying Model to a Growing Economy • Demand-side fluctuations • For Aggregate supply – grows, and • If: Aggregate demand – grows faster • Faster growth • More inflation • Economic boom • If: Aggregate demand – grows slower • Slower growth • Less inflation • Economic recession

  33. S0 Figure 11 S1 The effects of faster growth of aggregate demand A C 120 Price Level (P) (2000=100) 113 D2 D0 D2 D0 S1 S0 11,000 11,500 Real GDP (Y) in Billions of 2000 Dollars

  34. Figure 12 S0 S1 The effects of slower growth of aggregate demand A E 115 Price Level (P) (2000=100) 113 D3 D0 D0 D3 S1 S0 11,000 11,165 Real GDP (Y) in Billions of 2000 Dollars

  35. Applying Model to a Growing Economy • Supply-side fluctuations • For Aggregate demand – grows, and • If: Aggregate supply – shifts inward • Real output – decline slightly • Prices – rapid increase • Stagflation • If: Aggregate supply – grows faster • Favorable supply shock • Faster economic growth • Lower inflation

  36. Figure 13 Stagflation from an adverse supply shock S0 S1 B E 39.0 D0 D1 31.8 Price Level (2000=100) D1 D0 S0 S1 4,342 4,311 Real GDP (Y) in Billions of 2000 Dollars

  37. Figure 14 S0 The effects of a favorable supply shock S1 Normal growth of aggregate supply Effect of favorable supply shock C A B D0 D1 Price Level (P) D0 D1 S1 S0 Real GDP (Y)

  38. Big Picture • Chapter 8: composition of AD and the volatility of investment • Chapter 9: changes in investment have multiplier effects on AD (given price) • This chapter: show how shifts in AD curve cause fluctuations in both GDP and price

  39. A Role For Stabilization Policy Economy’s self-correcting mechanism Works slowly Government stabilization policy Improve workings of free market

  40. Summary AS curve: upward slope Shifts of AS curve Equilibrium of AS-AD Self-Correcting Mechanism of Economy The process might be slow Need government stabilization policy

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