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1. Aggregate Supply

2. The Aggregate Supply Curve aggregate supply The total supply of all goods and services in an economy. The Aggregate Supply Curve: A Warning aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. The aggregate supply curve is not a market supply curve, and it is not the simple sum of all the individual supply curves in the economy. Because many firms in the economy set prices as well as output, we can say an “aggregate supply curve” is really a “price/output response” curve—a curve that traces out the price decisions and output decisions of all firms in the economy under a given set of circumstances.

3. The Aggregate Supply Curve Aggregate Supply in the Short Run The Short-Run Aggregate Supply Curve In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, Y*, the curve is vertical.

4. The Aggregate Supply Curve Aggregate Supply in the Short Run Why an Upward Slope? Wages are a large fraction of total costs and wage changes lag behind price changes. This gives us an upward sloping short-run AS curve. Why the Particular Shape? At some level the overall economy is using all its capital and all the labor that wants to work at the market wage. At this level (Y*), the AS curve is vertical. At low levels of output, the AS curve is flatter. Small price increases may be associated with relatively large output responses. We may observe relatively “sticky” wages upward at this point on the AS curve.

5. The Aggregate Supply Curve Shifts of the Short-Run Aggregate Supply Curve cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve.

6. The Equilibrium Price Level equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect The Equilibrium Price Level At each point along the AD curve, both the money market and the goods market are in equilibrium. Each point on the AS curve represents the price/ output decisions of all the firms in the economy. P0 and Y0 correspond to equilibrium in the goods market and the money market and to a set of price/output decisions on the part of all the firms in the economy.

7. The Long-Run Aggregate Supply Curve The Long-Run Aggregate Supply Curve When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. Wages respond in the longer run, shifting the AS curve from AS0 to AS1. If wages fully adjust, output will be back at Y0. Y0 is sometimes called potential GDP.

8. The Simple “Keynesian” Aggregate Supply Curve The simple “Keynesian” view of the aggregate supply curve holds that at any given moment, the economy has a clearly defined capacity, or maximum, output. With planned aggregate expenditure of AE1 and aggregate demand of AD1, equilibrium output is Y1. A shift of planned aggregate expenditure to AE2, corresponding to a shift of the AD curve to AD2, causes output to rise but the price level to remain at P1. If planned aggregate expenditure and aggregate demand exceed YF, however, there is an inflationary gap and the price level rises to P3. Despite insights the kinked aggregate supply curve provides, most economists find it unlikely that the whole economy suddenly runs into a capacity “wall” at a specific level of output. As output expands, some firms and industries will hit capacity before others.

9. The Long-Run Aggregate Supply Curve Potential GDP potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. Short-Run Equilibrium Below Potential Output Although different economists have different opinions on how to determine whether an economy is operating at or above potential output, there is general agreement that there is a maximum level of output (below the vertical portion of the short-run aggregate supply curve) that can be sustained without inflation.

10. Monetary and Fiscal Policy Effects A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve Aggregate demand can shift to the right for a number of reasons, including an increase in the money supply, a tax cut, or an increase in government spending. If the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will be an increase in output with little increase in the price level from point A to point A .

11. Monetary and Fiscal Policy Effects A Shift of the Aggregate Demand Curve When the Economy Is Operating At or Near Maximum Capacity If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output from point B to point B.

12. Monetary and Fiscal Policy Effects Long-Run Aggregate Supply and Policy Effects It is important to realize that if the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output in the long run. The longer the lag time between wages and output prices, the greater the potential impact of monetary and fiscal policy on aggregate output. Some argue that wages do not fall during slack periods and that the economy can get “stuck” at an equilibrium below potential output. In this case, monetary and fiscal policy would be necessary to restore full employment.