A Lecture Presentation in Powerpoint Exploring Economics by Robert L. Sexton

A Lecture Presentation
in PowerPoint
to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
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Copyright © 2002 by Thomson Learning, Inc.

Chapter 21
Aggregate Supply and
Macroeconomic Equilibrium

21.1 The Aggregate Supply Curve
 The aggregate supply (AS) curve is the
relationship between the total quantity
of final goods and services that
suppliers are willing and able to produce
and the overall price level.
 The aggregate supply curve represents
how much RGDP suppliers will be
willing to produce at different price
levels.

 In fact, there are two aggregate supply
curves.
 Short-run aggregate supply (SRAS)
 a period when output can change in response
to supply and demand, but input prices have
not yet been able to adjust
 for example, nominal wages are assumed to adjust
slowly in the short run
 Long-run aggregate supply (LRAS)
 a period long enough for the prices of outputs
and all inputs to fully adjust to changes in the
economy

 In the short run, the aggregate supply
curve is upward sloping.
 At higher price levels, producers are willing
to supply more real output.
 At lower price levels, they are willing to
supply less real output.

The Short-Run Aggregate Supply Curve
SRAS
B
Price Level
PL1
A
PL0
0 RGDP0 RGDP1
RGDP
 Why would producers be willing to
supply more output just because the
price level increases?
 There are two possible explanations.
 profit effect
 misperception effect

 To many firms, input costs like wages
and rents are relatively constant in the
short run.
 The slow adjustments of input prices are
due to the longer-term input contracts
that do not adjust quickly to price
changes.
 So when the price level rises, output
prices rise relative to input prices
(costs), raising producers’ short-run
profit margins.
 These increased profit margins make it
in the producers’ self-interest to expand
their production and sales at higher price
levels.
 If the price level falls, output prices fall
and producers’ profits tend to fall.
 When output prices fall, producers will
find it more difficult to cover their input
costs, and consequently, will reduce
their level of output.
 The second explanation of the upward-
sloping short-run aggregate supply
curve is that producers can be fooled by
price changes in the short run.
 If a producer sees the price of his output
rising and thinks that the relative price
of his output is rising (i.e., that his
product is becoming more valuable in
real terms), he will supply more.

 It might be that it was not just his goods
prices that were rising; the prices of
many other goods and services could
also be rising at the same time as a
result of an increase in the price level.
 The relative price of his output, then,
was not actually rising, although it
appeared so in the short run.
 In this case, the producer was fooled
into supplying more based on his short-
run misperception of relative prices.
 Along the short-run aggregate supply
curve, we assume that wages and other
input prices are constant.
 This is not the case in the long run,
which is a period long enough for the
price of all inputs to fully adjust to
changes in the economy.

 Along the long-run aggregate supply
curve, we are looking at the relationship
between RGDP produced and the price
level, once input prices have been able
to respond to changes in output prices.

 Along the LRAS curve, two sets of
prices are changing the prices of
outputs and the price of inputs.
 Along the LRAS curve, a 10 percent
increase in the price of goods and
services is matched by a 10 percent
increase in the price of inputs.

 The long-run aggregate supply curve is
insensitive to the price level, reflecting
the fact that the level of RGDP
producers are willing to supply is not
affected by changes in the price level.

 The vertical LRAS curve will always be
positioned at the natural rate of output,
where all resources are fully employed.
 In the long run, firms will always
produce at the maximum sustainable
level allowed by their capital, labor, and
technological inputs, regardless of the
price level.

 The long-run equilibrium level is where
the economy will settle when
undisturbed, and all resources are fully
employed.

 The economy will always be at the
intersection of AS and AD but that will
not always be at the natural rate of
output.
 Long-run equilibrium will only occur
where AS and AD intersect along the
long-run aggregate supply curve at the
natural, or potential, rate of output.

21.2 Shifts in the
Aggregate Supply Curve
 The underlying determinant of shifts in
short-run aggregate supply is
production costs.
 Ceteris paribus, lower production costs will
motivate producers to produce more at any
given price level, shifting AS rightward.
 Higher production costs will motivate
producers to produce less at any given
price level, shifting AS leftward.

21.2 Shifts in the Aggregate Supply
Curve
 Any change in the quantity of any factor
of production available capital,
entrepreneurship, land, or labor can
cause a shift in both the long-run and
short-run aggregate supply curves.
 An increase in any of these factors can
shift both the LRAS and SRAS curves to
the right.
 A decrease in any of these factors can shift
both the LRAS and SRAS curves to the
left.

Shifts in Both Long-Run and Short-Run
Aggregate Supply
LRAS0 LRAS1 SRAS 0

SRAS1
Price Level
0 RGDPNR RGDP´NR
RGDP
21.2 Shifts in the
 Changes in the stock of capital will alter
the amount of goods and services the
economy can produce.
 Investing in capital improves the
quantity and quality of the capital stock.

21.2 Shifts in the
 More and better quality capital will
 lower the costs of production in the short
run,
 shifting the short-run aggregate supply
curve rightward,
 and allow output to be permanently greater
than before,
 shifting the LRAS rightward, ceteris
paribus.

21.2 Shifts in the
 Changes in human capital can also alter
the aggregate supply curve.
 Investments in human capital may
include educational or vocational
programs or on-the-job training.
 All of these investments in human
capital would cause productivity to rise.

21.2 Shifts in the
 As a result, the short-run aggregate
supply curve would shift to the right
because a more skilled workforce will
lower the costs of production, and the
LRAS curve would shift to the right
because greater output is achievable on
a permanent, or sustainable, basis,
ceteris paribus.

21.2 Shifts in the
 Through their inventive activity,
entrepreneurs lower costs and expand
real output possibilities.
 If entrepreneurial activities lower the
costs of production and expand what
can be produced with the resources
available to the economy, then the
short-run and long-run aggregate supply
curves both shift to the right.

21.2 Shifts in the
 Land is an all-encompassing definition
that includes all natural resources.
 An increase in usable natural resources,
such as successful oil exploration, would
lower the costs of production and expand
the economy’s sustainable rate of output,
shifting both SRAS and LRAS to the right.
 A decrease in the amount of natural
resources available would result in a
leftward shift of both SRAS and LRAS.
(OPEC is the prime example.)
21.2 Shifts in the
 The addition of workers to the labor
force, ceteris paribus, can increase
aggregate supply.
 women and baby boomers during the
1960s.
 It tends to depress wages and increase
short-run aggregate supply, ceteris
paribus.

21.2 Shifts in the
 An expanded labor force also increases
the economy’s potential output,
increasing LRAS. Increases or
decreases in labor productivity will also
affect the aggregate supply curve.
 Lower output per worker causes
production costs to rise and potential
real output to fall, resulting in a leftward
shift in both SRAS and LRAS.

21.2 Shifts in the
 Increases in government regulations
can make it more costly for producers;
this increase in production costs results
in a leftward shift of SRAS, and the
reduction in society’s potential output
would shift LRAS left as well.
 A reduction in government regulations
on businesses would lower the costs of
production and expand potential real
output, causing both SRAS and LRAS
to shift to the right.
21.2 Shifts in the
 Some factors shift SRAS but do not
impact LRAS.
 The most important of these factors are
changes in input prices and natural
disasters.
 The price of factors, or inputs, that go into
producing outputs will affect only SRAS if
they don’t reflect permanent changes in the
suppliers of some factors of production.

Shifts in Short-Run Aggregate Supply
But Not Long-Run Aggregate Supply
LRAS SRAS1
SRAS0
Price Level
PL1
PL0
0 RGDPNR
RGDP
21.2 Shifts in the
 If wages increase without a
corresponding increase in labor
productivity, then it will become more
costly for suppliers to produce goods
and services at every price level,
causing SRAS to shift to the left.
 LRAS will not shift because with the
same supply of labor as before,
potential output does not change.

21.2 Shifts in the
 If the price of steel rises, automobile
producers will find it more expensive to
do business because their production
costs will rise, again resulting in a
leftward shift in SRAS.
 The LRAS will not shift as long as the
capacity to make steel has not been
reduced.

21.2 Shifts in the
 It is supply and demand in factor
markets (like capital, land, and labor)
that cause input prices to change.
 The reason that changes in input prices
only affect SRAS and not LRAS, unless
they reflect permanent changes in the
supplies of those inputs, lies in our
definition of long-run aggregate supply.

21.2 Shifts in the
 The LRAS is vertical at the natural level
of real output, determined by the
supplies of the various factors of
production.
 A fall in input prices, which shifts SRAS
right, only shifts LRAS right if potential
output has risen, and this only occurs if
the supply of those inputs is increased.

21.2 Shifts in the
 Adverse supply shocks, such as natural
disasters, can increase the costs of
production.
 They could cause SRAS to shift to the
left, ceteris paribus.
 However, once the temporary effects of
these disasters have been felt, no
appreciable change in the economy’s
productive capacity has occurred, so
LRAS doesn’t shift as a result.
21.3 Macroeconomic Equilibrium
 The short-run equilibrium level of real
output and the price level are
determined by the intersection of the
aggregate demand curve and the short-
run aggregate supply curve.
 When this equilibrium occurs at the
potential output level, on the long-run
aggregate supply curve, the economy is
operating at full employment.

Long-Run Macroeconomic Equilibrium
LRAS
SRAS
Price Level
PL0 ELR
AD
0 RGDPNR
RGDP
 Only a short-run equilibrium that is at
potential output is also a long-run
equilibrium.
 Short-run equilibrium can change when
 the aggregate demand curve shifts or
 the short-run aggregate supply curve shifts
rightward or leftward,
 but the long-run equilibrium level of
RGDP only changes when the LRAS
shifts.
 Sometimes, these supply or demand
changes are anticipated; at other times,
however, the shifts occur unexpectedly.
Economists call these unexpected shifts
shocks.

 Short-run equilibrium can occur at less
than the potential output of the
economy, resulting in a contractionary
gap.
 Or it can temporarily occur beyond
potential output, resulting in an
expansionary gap.

Contractionary and Expansionary Gaps
Expansionary
Price Level
Price Level
LRAS LRAS LRAS gap
Contractionary SRAS SRAS SRAS

gap
PL2 ESR
ELR PL1 ELR
PL0
AD1 AD2
AD0
0 RGDP0 RGDPNR 0 RGDPNR 0 RGDPNR RGDP2
RGDP RGDP RGDP

 Demand-pull inflation occurs when the
price level rises as a result of an
increase in aggregate demand.
 The increase in AD causes an increase
in the price level and an increase in real
output, illustrated by a movement up
along the SRAS curve.
 This causes an expansionary gap.

 The increase in output as a result of the
increase in the price level is a result of
its effect on producers profits; firms
have an incentive to increase real
output when the prices of the goods
they are selling are rising faster than the
costs of the inputs they use in
production.

Demand-Pull Inflation
LRAS
SRAS
Price Level
PL1 E1
PL0 E0
AD1
AD0
0 RGDPNR RGDP1
RGDP
 The short-run result of an increase in
AD is a level of RGDP beyond full
employment.
 The potential output is an expansionary
gap.

 It seems peculiar that the economy can
operate beyond its potential, but this is
possible, temporarily, as firms
 encourage workers to work overtime,
 extend the hours of part time workers,
 hire recently retired employees,
 reduce frictional unemployment through
more extensive searches for employees,
 and so on.

 Short-run real output beyond potential
output (and employment beyond full
employment) cannot be sustained in the
long run.
 In the expansionary gap situation,
because the price level is now higher,
workers (and other input suppliers)
become disgruntled with real wages that
have not yet adjusted to the new price
level.
 Recall that along the SRAS curve,
wages and other input prices are
assumed to be constant. Therefore,
workers and input suppliers purchasing
power falls as output prices rise.
 (If prices have risen, but wages have
not risen as much, real wages have
fallen.) Because real (adjusted for
inflation) wages have fallen, workers
and other suppliers demand higher
prices in order to supply their inputs.
 As input prices respond to the higher
level of output prices, the SRAS curve
shifts to the left.
 Suppliers will continually seek higher
prices for their inputs until they reach
the new, long-run equilibrium.
 At that point, input suppliers purchasing
power is restored at full employment
equilibrium.

 The only long-run difference from the
initial equilibrium is the new, higher
price level.
 The 1970s and early 1980s witnessed a
phenomenon known as stagflation,
where lower growth and higher prices
occurred together.

 Some economists believe that this was
caused by a leftward shift in the
aggregate supply curve.
 If aggregate demand did not change
significantly and the price level
increased, then the inflation was caused
by supply-side forces, not demand.
This is called cost-push inflation.

Cost-Push Inflation
LRAS SRAS1
SRAS0
Price Level
PL1 E1
PL0 E0
AD
0 RGDP1 RGDPNR
RGDP
 The primary culprits responsible for the
leftward shift in SRAS in the 1970s were
oil price increases.
 An increase in input prices can cause
the SRAS curve to shift to the left, and
this spelled big trouble for the U.S.
economy:
 higher price levels,
 lower output, and
 higher rates of unemployment.
 Starting with the economy initially at full
employment equilibrium, suppose there
is a sudden increase in input prices,
such as the increase in the price of oil.

 This increase would shift the SRAS curve
to the left.
 As a result, the price level rises and real
output falls below potential output.
 Now firms may demand fewer workers as
a result of the higher input costs that
cannot be passed on to the consumers.
 The result is higher prices, lower real
output, more unemployment, and a
contractionary gap.
 As far as energy prices are concerned,
the 1980s witnessed falling oil prices as
OPEC lost some of its clout, and many
non-OPEC oil producers increased
production.
 The net result was a rightward shift in
the SRAS curve.
 Holding AD constant, this rightward shift
in SRAS would lead to lower prices,
greater output, and lower rates of
unemployment.
 Just as cost-push inflation can cause a
recession, so can a decrease in AD. A
fall in AD would reduce real output and
the price level, and increase
unemployment in the short run—a
contractionary gap.
 Many recoveries from recessions occur
because of increases in aggregate
demand that take the economy back to
potential output.
A Short-Run Decrease in Aggregate Demand
LRAS
SRAS
Price Level
PL0 E0
PL1 E1
AD0
AD1
0 RGDPNR RGDP1
RGDP
 It is possible that the economy would
self-correct through declining wages
and prices.
 In a recession, unemployed workers
and other input suppliers will bid down
wages and prices.

 The resulting reduction in production
costs shifts the short-run aggregate
supply curve to the right.
 Eventually, the economy returns to a
long-run equilibrium at potential output
and a lower price level.

Self-Adjusting to a Contractionary Gap
LRAS SRAS0
Price Level
SRAS1
PL1 E1
PL2 E2
AD
0 RGDP1 RGDPNR
RGDP
 Many economists believe that wages
and prices may be very slow to adjust,
especially downward.
 This downward wage stickiness may
lead to prolonged periods of recession,
by making the economy’s adjustment
mechanism slower.

 Wages and prices may be sticky
downward because of
 long-term labor contracts,
 a legal minimum wage,
 employers paying efficiency wages,
 and menu costs.

 If the economy is currently in an
expansionary gap, with output greater
than potential output, the price level is
higher than workers anticipated, and
workers’ and input suppliers’ purchasing
power has fallen.

 Consequently, workers and other
suppliers demand higher prices to be
willing to supply their inputs, shifting the
short-run aggregate supply to the left,
until they reach the long-run equilibrium
at potential output. Input suppliers’
purchasing power is restored at a higher
price level.

Adjusting to an Expansionary Gap
SRAS1
LRAS
SRAS0
PL1 E1
Price Level
PL0 E0
AD
0 RGDPNR RGDP0
RGDP

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A Lecture Presentation

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LRAS0 LRAS1 SRAS 0

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Contractionary SRAS SRAS SRAS

RGDP RGDP RGDP

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