Chapter
11 Aggregate Supply
Aggregates
Supply is the relationship between the price level in the economy and the
quantity of aggregate output firms are willing and able to supply, other things
constant.
The
greater the supply of resources, the better the technology, the more effective
production incentives, provided by economic institutions, the greater aggregate
supply.
The
demand for labor is derived from its productivity, which in turn depends upon
capital (including human capital), other resources, and technology. If the
production function increases the demand for labor rises (and vice versa).
Profit
maximizing firms will hire when the real wage equals the marginal physical
product of labor.
B.
Labor Supply
Labor
is the most important resource – 70% of production costs.
The
higher the wage, the more willing and able people are to work, supply labor
hours.
Nominal wage – the wage measured in terms of current dollars;
the dollar amount on a paycheck
Real wage – the wage measured in terms of dollars of constant
purchasing power; hence, the wage measured in terms of the quantity of goods
and services it will purchase
The
higher the price level, the less any given dollar wage (nominal wage) will
purchase, so the less attractive that dollar wage is to workers.
Wage
contracts are generally settled in terms of nominal wages.
So
workers and firms reach agreements based on the expected price level (and the expected real wage).
C.
Equilibrium in the Labor
Market Determines Potential Output and the Natural Rate of Unemployment
Example:
Resource owners and firms negotiate the wage based on what they expect the
inflation rate to be. If firms and resource owners expect inflation to be 3%,
they may agree on a wage increase of 4% this year (or 1% increase in real
wages). If inflation turns out to be 3%, the agreed-upon wage is the expected
real wage, so everyone is happy.
The
potential output is the output produced when there are no surprises associated
with the price level.
Potential
Output –
The economy’s maximum sustainable output level, given the supply of resources,
technology, and production incentives; the output level when there are no
surprises about the price level. (natural rate of output, full-employment
output)
Natural
Rate of Unemployment – The unemployment rate that occurs when the economy is producing its
potential level of output.
When
actual price level turns out as anticipated, the expectations of both workers
and firms are fulfilled, and the economy produces its potential output.
A.
Employment
can exceed the potential level if real wages are below the market clearing
level.
B.
Employment
is below potential if real wages are above the market clearing level
C.
Why
sticky wages can result in non-market clearing real wages and employment.
D.
How
the actual price level different from the expected price level affects
non-market clearing real wages and employment
Short
run – A
period during which at least some resource prices, especially those for labor,
are fixed by agreement.
Suppose
that given an expected price level, a firm and its workers have agreed on a
wage.
What
happens if the price level turns out to be higher than expected?
ŕ Firms are happy. They
receive a higher price for what they are selling while wages are fixed. Because
a price level that is higher than expected results in higher profits, firms
have an incentive in the short run to expand production beyond the economy’s
potential level. (beyond “normal capacity”)
1.
Why Costs Rise When Output
Exceeds Potential
As output expands, the cost of additional output
increases.
a.
Economy
expands ŕ unemployment declines ŕ extra workers become hard to find (They may
need extra pay to draw them into the labor force, they may be less qualified,
you may have to pay premiums for overtime hours.)
The nominal cost of labor
increases as output expands in the short run.
(Even though
wages are fixed by contract.)
b.
Production
increases ŕ demand for other resources
(non-labor) increases as well. ŕ prices for these resources
will increase due to greater scarcity.
Firms expand production as long as revenue from
additional production exceeds costs.
**Because the prices of some resources are fixed by
contracts, the price level rises faster than the per-unit production cost, so
firms increase the quantity supplied.
2.
Why are workers willing to
increase their labor supply?
When the price level exceeds expectations (real
wages fall), why are workers willing to increase their labor supply?
The impact of a money illusion, when nominal wages
increase even though real wages decrease.
Efficiency Wage Theory – The idea that keeping
wages above the level required to attract a sufficient pool of workers makes
workers compete to get and keep their jobs and results in greater productivity.
Resource
suppliers and firms expect a certain price level.
If
the price level is lower than expected, production is less profitable, firms
reduce their quantity supplied, so the economy’s output is below its potential.
-
some
workers laid off
-
those
who keep jobs may work fewer hours
-
unemployment
exceeds the natural rate
Price
level higher than expected ŕ firms increase quantity
supplied beyond potential output, per-unit cost of additional production
increases
Price
level lower than expected ŕ firms reduce output below
potential output,
There
is a direct relationship between the actual price level and the quantity of
aggregate output supplied.
Short-run
aggregate supply curve (SRAS) – A curve that shows the direct relationship
between the price level and the quantity of aggregate output supplied in the
short run.
Short
run -
Period of time in which some resource prices fixed (like those for labor).
Think
of short run as the duration of labor contracts.
Suppose
the expected price level is 130.
If
the price level turns out to be 130 ŕ producers supply the
economy’s potential output ŕ unemployment is at the
natural rate
A
higher price level increases output, if the expected price level does not change,
since the real wage rate decreases.
The
slope of the SRAS curve depends on how sharply the cost of additional
production rises as aggregate output expands. It becomes steeper as output
increases because resources become scarcer.
A.
Actual Price Level Higher
than Expected
Expected
price level of 130.
Equilibrium
price and output depend on aggregate demand.
If
Aggregate Demand is greater than expected, short-run equilibrium may not be at
a price level of 130.
1.
Short-run Equilibrium
Short-run
Equilibrium
– Combination of price level and real GDP, where the aggregate demand curve
intersects the short-run aggregate supply curve.
Expansionary Gap – The amount by which
actual output in the short run exceeds the economy’s potential output.
When
real GDP exceeds potential GDP, employment is less than the natural rate.
ŕ Employees working over
time.
ŕ Machines are pushed to the
limit.
ŕ Farmers put extra crops
between usual plantings.
Nominal
wage based on expected price level of 130 is a lower real wage.
The
more the short-run output exceeds the economy’s potential, the larger the
expansionary gap and the greater the upward pressure on the price level.
2.
Long-run Equilibrium
Long
Run – A
period during which wage contracts and resource price agreements can be
renegotiated; the level of output when there are no price surprises.
1.
Because
higher than expected price levels makes real wage lower than expected, when
workers have the chance to renegotiate, they will want a higher wage.
2.
This
raises production costs for the firm.
3.
Short
run supply curve shifts to the left, reflecting higher expected price level.
Long-run
Equilibrium
– Combination of price level and real GDP, where 1. Actual price level equals
expected price level 2. Quantity supplied equals potential output, and 3.
Quantity supplied equals quantity demanded.
In
real terms, the situation is no different at point a than at point c.
B.
Actual Price Level Lower
than Expected
Expected
price level of 130.
Equilibrium
price and output depend on aggregate demand.
If
Aggregate Demand is less than expected, short-run equilibrium may not be at a
price level of 130.
1.
Short-run Equilibrium
Contractionary Gap – The amount by which
actual output in the short run falls below the economy’s potential output.
ŕ Nominal wage negotiated
translates into a higher wage in the short run.
2.
Long-run Equilibrium
Long
Run
ŕ Since price level is lower,
firms no longer willing to pay a higher nominal wage.
ŕ Unemployment higher than
the natural rate
ŕ More workers compete for
jobs, putting downward pressure on the wage.
ŕ Firms negotiate lower
wages, lowers the cost of production, supply curve shifts down.
If
the price level and nominal wage are flexible enough, the short-run aggregate
supply curve will move outward until the economy produces its potential output.
Graph:
C.
Tracing Potential Output
If
wages and prices are flexible enough, the economy will produce its potential
level of output in the long run.
Long-run
Aggregate Supply Curve – The vertical line drawn at the economy’s potential output; aggregate
supply when there are no price surprises.
LRAS
depends on the supply of resources in the economy, the level of technology, and
the production incentives provided by the formal and informal institutions of
the economic system.
Equilibrium
price level depends on AD.
D.
Evidence on Aggregate Supply
Natural
Rate estimates range from 4 to 6%
-
Expansionary
gaps create labor shortages that lead to higher nominal wages.
-
Contractionary
gaps often don’t put enough downward pressure on wages. Studies show that the
nominal wage is slow to adjust to high unemployment.
III.
Changes in Aggregate Supply
A.
Increases in Aggregate
Supply
LRAS
depends on
1.
willingness
and ability of households to supply resources
2.
technology
3.
economic
system
Example:
Increase in the quality and quantity of the labor force. (Gradual increase in
the supply of resources.)
Beneficial
Supply Shocks
– Unexpected events that increase aggregate supply, sometimes only temporarily.
-Abundant
harvests
-Discoveries
of natural resources
-Technological
breakthrough
B.
Decrease in Aggregate Supply
Adverse
Supply Shocks
– Unexpected events that reduce aggregate supply, sometimes only temporarily.
If
the effect is temporary, only the short run supply curve shifts.