AGGREGATE SUPPLY (AS) AND THE EQUILIBRIUM PRICE LEVEL

• The AS curve in short run (SRAS)• Shifts of SRAS• Equilibrium price level• Long run AS• Monetary and Fiscal Policies Effect.

AS = the total supply of all goods and services in an economy.AS curve = a curve that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. AS curve in the short run

Price level, P

Agg output, (income), Y

AS

In the short run AS curve has a positive slope.At lower levels of aggregate output, the curve is fairly flat because firms are likely to have excess capacity.As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical.

3 reasons why the SRAS curve slopes upward:1. Wages of many workers remain fixed by contract for several years.2. Firms are often slow to adjust wages: many workers have their wages

adjusted only once a year. Due to these 2 reasons, when AD increase the profit would be increasing if

the firms increase price & output.3. Menu costs make some prices sticky. Menu costs = the costs to firms of changing prices. Example: for a

restaurant, changing price would be costly because it would involve printing new menus or catalogs.

If the demand for their products is higher, some firms may not be willing to increase price because of menu costs. Because of their relatively low price, these firms will find their sales increasing, which will cause them to increase output.

Conclusion: the response of the overall economy to the AD increase will be an increase in price level and output - a positive slope of SRAS curve.

SRAS curve will be determined by the costs of production. What factors determine the costs of production? The key factors:• Input prices (wage & materials)• The state of technology.• Taxes, subsidies, or economic regulations.

Shifts of the SRAS curve1. A decrease in AS:

A leftward shift of AS curve from AS0 to AS1, could be caused by an increase in costs, including an increase in input prices (wage rates or materials) or increase in taxes.

AS0

AS1

Agg output (income), Y

Price level, P

2. Increase in AS:

A rightward shift of AS curve from AS0 to AS1 could be caused by a decrease in costs (such as a decrease in inputs prices or taxes or increase in subsidies) and technological change.

AS0 AS1

Agg output (income), Y

Price level, P

The Equilibrium Price Level

The equilibrium P level = the P level at which the AD & AS curves intersect.

AS

AD

Price level, P

Agg output (income), Y

P0

Y0

E

At each point along AD curve, both money market and goods market are in equilibrium.Each point on the AS curve represents the price / output decisions of all firms in the economy.At point E: P0 = equilibrium price level. Y0 = real output demanded/ supplied.

The long-run AS curve (LRAS) :

In the long run, the economy operates at full employment & changes in the price level do not affect employment. LRAS curve is vertical at full employment level of real GDP (Yf).

In the long run, wages and other input prices rise and fall to match changes in price level. So price-level changes do not affect firm’s profit & thus they create no incentive for firms to alter their output.

LRAS

Yf Agg output (income), Y

Price level, P

AD0

AD1

AS0

AS1LRAS

Yf Agg output (income), Y

P0

P1

P2

Expansionary Monetary & Fiscal PolicyExpansionary Monetary Policy: MsExpansionary Fiscal Policy: G or TAn expansionary policy aims at stimulating the economy. Expansionary policy shift the AD curve to the right.How do these policies affect the equilibrium P & Y? A shift of AD curve when the economy is on the nearly flat part.

Y0 Y1

P0

P1

AS

AD1

AD0

Price level, P

Agg output (income), Y

If the AD curve shifts rightwards (from AD0 to AD1) when the economy is on the nearly flat portion of AS curve, the result will be an increase in equilibrium Y (from Y0 to Y1) with little increase in the price level (from P0 to P1).The increase in equilibrium Y is much greater than the increase in equilibrium P.

A shift of AD curve when economy is operating at or near maximum capacity:

If AD curve shifts rightwards (from AD0 to AD1) when the economy is operating near full capacity, the result will be an increase in the price level (from P0 to P1) with little increase in output (from Y0 to Y1).

Conclusion: the increase in the equilibrium price (P) is much more than the increase in output (Y).

AD0

AD1

AS

P0

P1

Y0 Y1

Price level, P

Agg output (income), Y