1. Aggregate Supply
1
CHAPTER
11
© 2003 South-Western/Thomson Learning

2. Aggregate Supply in Short Run
Aggregate 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 prices
State of technology
Set of formal and informal institutions that
structure production incentives
2

3. Labor and Aggregate Supply
Labor 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, and
Household preferences for work versus
leisure
3

4. 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
However, the purchasing power
of any given nominal wage
depends on the economy’s price
level
4

5. Labor and Aggregate Supply
The 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 dollars
Real wage measures the wage in constant
dollars  dollars measured by the goods
and services they will buy
5

6. Real and Nominal Wages
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 contract
Implicit agreements would be those based
on labor market practices
6

7. Potential Output
If 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
level
7

8. 8
Potential Output
Potential output can be thought of as
the economy’s maximum sustainable
output level, given the
Supply of resources
State of technology
Formal and informal production incentives
Often referred to by other terms
Natural rate of output
Full-employment rate of output

9. Natural Rate of Unemployment
Natural rate of unemployment
The unemployment rate that occurs when the
economy is producing its potential GDP
The rate that prevails when cyclical
unemployment is zero
The number of job openings is equal to the
number unemployed for frictional, structural,
and seasonal reasons
Estimates of the natural rate range from
about 4 to 6% of the labor force
9

10. Actual Price Higher than Expected
Since the prices of many resources
are fixed for the duration of the
contract, firms welcome a price level
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
10

11. Actual Price Higher than Expected
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
11

12. 12
Why Costs Rise
As output expands above potential
GDP, the cost of producing this
additional output increases
Additional workers are harder to find
Some workers may not be properly
prepared
The prices of those resources purchased
in markets where prices are flexible will
increase reflecting their increased scarcity
Firms use their capital resources more
intensively

13. 13
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

14. 14
Summary
If 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

15. Actual Price Lower than Expected
Production is less attractive to firms
because the prices they receive for their
output are on average lower than they
expected
However, 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
15

16. 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
16

17. 17
Summary
If the price level is higher than
expected
Firms increase the quantity supplied
beyond the economy’s potential
The per-unit cost of additional
production increases
If the price level is lower than
expected
Firms reduce output below the
economy’s potential output
Prices fall more than costs

18. Short-Run Aggregate Supply Curve
What 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
18

19. Exhibit 1:Short-Run Aggregate Supply Curve
a
19
Price level
140
130
120
Potential
output
SRAS130
0 10.0 Real GDP (trillions of dollars)
The expected price level is 130;
the SRAS is based on that
expected price level.
If the price level turns out to be
130 as expected, producers
supply the economy’s potential
level of output, $10.0 trillion.

20. Exhibit 1: Short-Run Aggregate Supply Curve
a
20
P ric e le ve l
140
130
120
Potential
output
SRAS 130
The short-run
aggregate supply
becomes steeper
as output
increases because
resources become
more costly as
output increases
0 10.0 R eal GDP (trillions of dollars)

21. Exhibit 2: Expansionary Gap
21
output
a
130
Potential
SRAS 130
0 10.0 Real GDP
(trillions of
dollars)
Price level
140
Expansionary gap
135
AD
b
10.2

22. Exhibit 2: Expansionary Gap
output
22
c
a
130
Potential
0 R e a l G D P 10.0
(trillions of dollars)
SRAS 130
Price level
140
SRAS 140
Expansionary gap
135
AD
b
10.2

23. Exhibit 3: Contractionary Gap
23
130
Potential
output
d
0 10.0
SRAS130
Price level
a
Contractionary gap
125
9.8
AD
120 e

24. Exhibit 3: Contractionary Gap
24
130
Potential
output
d
0 10.0
SRAS130
Price level
a
Contractionary gap
125
9.8
AD
SRAS120
120 e

25. Contractionary Gap
The 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
25

26. Long-Run Aggregate Supply
The long-run aggregate supply curve,
LRAS, depends on the
supply of resources in the economy
level of technology
production 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
26

27. Exhibit 4: Long-Run Aggregate Supply Curve
AD
27
The initial price
level of 130 is
determined by the
intersection of AD
with the long-run
aggregate supply
curve.
130
Potential output
LRAS
a
c
0 Real GDP (trillions of dollars)
10.0
AD''
120
b
AD'
140
Price level

28. 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
28

29. Wage Flexibility and Employment
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
wage
The real wage will fall as long as the
price level increases more than the
nominal wage
29

30. 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 technology
institutional underpinnings of the
economic system
30

31. Exhibit 6: Change in the Supply of Resources
LRAS LRAS'
31
Price level
0 10.0 10.5 Real GDP
(trillions of dollars)
A gradual increase
in the supply of
resources increases
the potential level of
real GDP  the
long run aggregate
supply curve shifts
from LRAS to
LRAS'

32. 32
Supply Shocks
Supply shocks are unexpected events
that change aggregate supply,
sometimes only temporarily
Beneficial supply shocks increase
aggregate supply; examples include
Abundant harvests that increase the
supply of food
Discoveries of natural resources
Technological breakthroughs that allow
firms to combine resources more
efficiently
Sudden changes in the economic system
that promote more production

33. Exhibit 7: Beneficial Supply Shock
33
LRAS
LRAS'
0 10.0 Real GDP
(trillions of dollars)
130
AD
a
SRAS130
10.2
125
SRAS125
b
Here, the beneficial supply
shock is assumed to be a
technological breakthrough,
which shifts the SRAS from
SRAS130 to SRAS125 and the
long-run aggregate supply
curve from LRAS to LRAS
´.
Thus, for a given aggregate
demand curve, a beneficial
supply shock leads to an
increase in output and a
decrease in the price level.
Price level

34. Decreases in Aggregate Supply
Adverse supply shocks are sudden,
unexpected events that reduce
aggregate supply, again sometimes,
only temporarily
Drought could reduce the supply of a
variety of resources
Government instability
Terrorist attacks
34

35. Exhibit 8: Adverse Supply Shock
35
Price level
LRAS
10.0
0 Real GDP
(trillions of dollars)
130
SRAS130
AD
a
135
LRAS''
SRAS135
c
9.8
The adverse supply is
shown as the leftward
shift of both the short
and long-run aggregate
supply curves with the
result that the price
level increases and the
level of output declines
 stagflation as
equilibrium moves
from point a to point c