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ECON203 Principles of Macroeconomics

Week 7Topic: Aggregate Supply

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Learning outcomes for Learning outcomes for student revisionstudent revision

To learn aboutAfter studying these topics you should be able to:Understand the meaning and factors that affect

Aggregate Supply (AS or SAS)

Explain the meaning and differences between Equilibrium output (Ye) and Potential output (YP) and why and how they will change

Show changes using an AS graph and explain their output and price implications

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Aggregate Supply Aggregate Supply Aggregate Supply is the total amount of final goods (G) and services (S) that firms in the country plan on selling during a specific time period.

The aggregate quantity of G&S supplied depends on 5 factors → quantity of labour (L ), Land and natural resources, Entrepreneurial talent, quantity of capital (K ), technology (T )

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Aggregate Supply Aggregate Supply

Aggregate Supply shows the relationship between the price level and quantity of real GDP supplied. Short-run Aggregate Supply (SAS) is the relationship between the quantity of real GDP supplied and the output price level when factor prices (and potential GDP) are constant.– In the short-run: As prices rise producers are willing

to increase quantity supplied (move along SAS) and employ more labour.

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SASSAS Other things remaining the same, the higher the price level, the greater the quantity of real GDP supplied , and the lower the price level, the smaller the quantity of real GDP supplied. P Price level ( GDP Price Index )

2005=100 Quantity of real GDP supplied

Trillions of 2005 dollars

E 120 14.0

D 115 13.5

C 110 13.0

B 105 12.5

A 100 12.0

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Changes in Changes in Aggregate Aggregate Supply in Short Run. Supply in Short Run.

SAS

0

85

115

95

105

125

860 900 940 880 920Real GDP

GPL

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Why the AS Curve Slopes Why the AS Curve Slopes Upward?Upward?

The answer is:

If the price level rises , firms will increase the quantity of labor employed and the level of production (assuming money wages constant). Why?

• To change its output rate, a firm must change the quantity of labor that it employs. If the additional labor costs less than the revenue the firm generates, it is profitable to hire more labor otherwise unprofitable.

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Why the AS Curve Slopes Why the AS Curve Slopes Upward?Upward?

So if the price level rises and the money wage rate doesn’t change (real wage rate decreases) an extra hour of labor becomes profitable and both the quantity of labor demanded and production increase.If the price level falls, firms will decrease the quantity of labor employed and the level of production (assuming money wages constant). Why? If the price level falls and the money wage rate doesn’t

change (real wage rate increases) an extra hour of labor becomes unprofitable and both the quantity of labor demanded and production decrease.

What is Real Wage Rate?What is Real Wage Rate?

Real wage rate shows how much the money wage rate buys goods and services.

• The Real Wage Rate= the money wage rate divided by the price level ( GDP price index)

• If the money wage rate denoted by W and,• If the price level denoted by P • Then;

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P

W Rate WageReal The

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Why the AS Curve Slopes Why the AS Curve Slopes Upward?Upward?

• So if the price level rises relative to wages, profits increase, the number of firms in business increase, and the quantity of real GDP supplied as well as employment increases.

• And if the price level falls relative to wages, profits decrease, the number of firms in business decreases, and the quantity of real GDP supplied as well as employment decreases.

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Changes in SASChanges in SAS ( (Shift of the SAS curve))

• Aggregate supply changes when any influence on production plans other than price level changes.

Aggregate supply changes when:1)Potential GDP changes (economic growth).2)The money wage rate changes.3)The money prices of other resources change.

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Changes in SASChanges in SAS ( (Shift of the SAS curve)) Change in Potential GDP

•Anything that changes potential GDP changes aggregate supply and shifts the aggregate supply curve.•If potential GDP increases then potential GDP line and SAS curve shift to the right.

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Initial new Price Potential GDP Potential GDP Level SAS1 SAS2 130 120

C C” 110 100

90

Real GDP Supplied 0 12 13 14 15

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Changes in SAS (Changes in SAS (Shift of the SAS curve))

Changes in Money Wage Rate• A change in the money wage rate (nominal

wage) changes aggregate supply because it changes firm’s costs.

• The higher the money wage rate, the higher are the firms’ costs and the smaller is the quantity that firms are willing to supply at each price level. It does not affect the potential GDP. An increase in money wage a leftward (upward) shift of SAS curve. In alternative situation, SAS shifts to the right (downward)

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Price Potential GDP Level

120

110

100

90

0 11.5 12 13 14 15 Real GDP

D

C

SAS2

SAS0

SAS1

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Changes in SAS (Changes in SAS (Shift of the SAS curve))

Change in Money Prices of Other Resources• A change in money prices of other inputs/resources

(such as Changes in world oil prices, Changes in the weather,

Technological change) has the same effect on firms’ production plans as a change in the money wage rate. It changes firms’ costs.

• If the money prices of other resources rise, the price level is the same, the real costs change and the quantity that firms are willing to supply decreases at each price level ( SAS shifts to the left ). In alternative situation, SAS shifts to the right.

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SummarySummaryMovements along the aggregate supply curves

– If output prices change but input prices do not, we have a movement along the SAS curve.

– If both output and input prices change at the same rate, then we have a movement along the LAS curve.

Shifts of aggregate supply curvesWhen anything other than a change in real GDP or price level,

SAS curve itself shifts. Such as– Changes in prices of other resources (such as world

oil)– Changes in the weather– Technological change– Nominal (money) wage rate– Potential GDP

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Now it’s over for Now it’s over for today. Do you have today. Do you have any question?any question?