economics_of_money_banking__financial_markets

F I G U R E 2 Aggregate Supply

Curve in the Short Run

A rise in the costs of production shifts the supply curve leftward from AS1 to AS2.

The key feature of aggregate supply is that as the price level increases, the quantity of output supplied increases in the short run. Figure 2 illustrates the positive relationship between quantity of output supplied and price level. Suppose that initially the quantity

Shifts in the

Aggregate Supply

Curve

of output supplied at a price level of 1.0 is $4 trillion, represented by point A. A rise in the price level to 2.0 leads, in the short run, to an increase to $6 trillion in the quantity of output supplied (point B). The line AS1 connecting points A and B describes the relationship between the quantity of output supplied in the short run and the price level and is called the aggregate supply curve; as you can see, it is upward-sloping.

To understand why the aggregate supply curve slopes upward, we have to look at the factors that cause the quantity of output supplied to change. Because the goal of business is to maximize profits, the quantity of output supplied is determined by the profit made on each unit of output. If profit rises, more output will be produced, and the quantity of output supplied will increase; if it falls, less output will be produced, and the quantity of output supplied will fall.

Profit on a unit of output equals the price for the unit minus the costs of producing it. In the short run, costs of many factors that go into producing goods and services are fixed; wages, for example, are often fixed for periods of time by labor contracts (sometimes as long as three years), and raw materials are often bought by firms under long-term contracts that fix the price. Because these costs of production are fixed in the short run, when the overall price level rises, the price for a unit of output will be rising relative to the costs of producing it, and the profit per unit will rise. Because the higher price level results in higher profits in the short run, firms increase production, and the quantity of aggregate output supplied rises, resulting in an upward-sloping aggregate supply curve.

Frequent mention of the short run in the preceding paragraph hints that the aggregate supply curve (AS 1 in Figure 2) may not remain fixed as time passes. To see what happens over time, we need to understand what makes the aggregate supply curve shift.3

We have seen that the profit on a unit of output determines the quantity of output supplied. If the cost of producing a unit of output rises, profit on a unit of output falls, and the quantity of output supplied falls. To learn what this implies for the position of the aggregate supply curve, letÕs consider what happens at a price level of 1.0 when the costs of production increase. Now that firms are earning a lower profit per unit of output, they reduce production, and the quantity of aggregate output supplied falls from $4 (point A) to $2 trillion (point A ). Applying the same reasoning at point B indicates that aggregate output supplied falls to point B . What we see is that the aggregate supply curve shifts to the left when costs of production increase and to the right when costs decrease.

http://hadm.sph.sc.edu /Courses/Econ/SD/SD.html

An interactive lecture on aggregate supply and demand.

The equilibrium level of aggregate output and the price level will occur at the point where the quantity of aggregate output demanded equals the quantity of aggregate output supplied. However, in the context of aggregate supply and demand analysis, there are two types of equilibrium: short-run and long-run.

Equilibrium in

the Short Run

C H A P T E R 2 5 Aggregate Demand and Supply Analysis 589

Figure 3 illustrates an equilibrium in the short run in which the quantity of aggregate output demanded equals the quantity of output supplied; that is, where the aggregate demand curve AD and the aggregate supply curve AS intersect at point E. The equilibrium level of aggregate output equals Y *, and the equilibrium price level equals P *.

As in our earlier supply and demand analyses, equilibrium is a useful concept only if there is a tendency for the economy to head toward it. We can see that the economy heads toward the equilibrium at point E by first looking at what happens when we are at a price level above the equilibrium price level P *. If the price level is at P , the quantity of aggregate output supplied at point D is greater than the quantity of aggregate output demanded at point A. Because people want to sell more goods and services than others want to buy (a condition of excess supply) , the prices of goods and services will fall, and the aggregate price level will drop, as shown by the downward arrow. This decline in the price level will continue until it has reached its equilibrium level of P * at point E.

When the price level is below the equilibrium price level, say at P , the quantity of output demanded is greater than the quantity of output supplied. Now the price level will rise, as shown by the upward arrow, because people want to buy more goods than others want to sell (a condition of excess demand) . This rise in the price level will continue until it has again reached its equilibrium level of P * at point E.

Equilibrium in

the Long Run

Usually in supply and demand analysis, once we find the equilibrium at which the quantity demanded equals the quantity supplied, there is no need for additional discussion. In aggregate supply and demand analysis, however, that is not the case. Even when the quantity of aggregate output demanded equals the quantity supplied, forces operate that can cause the equilibrium to move over time. To understand why, we must remember that if costs of production change, the aggregate supply curve will shift.

The most important component of production costs is wages (approximately 70% of production costs), which are determined in the labor market. If the economy is booming, employers will find that they have difficulty hiring qualified workers and may even have a hard time keeping their present employees. In this case, the labor

F I G U R E 3 Equilibrium in the

Short Run

Equilibrium occurs at point E at the intersection of the aggregate demand curve AD and the aggregate supply curve AS.

F I G U R E 4 Adjustment to Long-

Run Equilibrium in Aggregate Supply

and Demand Analysis

In both panels, the initial equilibrium is at point 1 at the intersection of AD and AS1. In panel (a), Y1 Yn , so the aggregate supply curve keeps shifting to the left until it reaches AS 3, where output has returned to Yn . In panel (b), Y1 Yn , so the aggregate supply curve keeps shifting to the right until output is again returned to Yn . Hence in both cases, the economy displays a self-correcting mechanism that returns it to the natural rate level of output.

C H A P T E R 2 5 Aggregate Demand and Supply Analysis 591

Aggregate Output, Y

(a) Initial equilibrium in which Y > Yn

Aggregate Output, Y

(b) Initial equilibrium in which Y < Yn

A characteristic of the economy that causes output to return eventually to the natural rate level regardless of where it is initially.

In panel (b), the initial equilibrium at point 1 is one at which output Y1 is below the natural rate level. Because unemployment is higher than the natural rate, wages begin to fall, shifting the aggregate supply curve rightward until it comes to rest at AS 3. The economy slides downward along the aggregate demand curve until it reaches the long-run equilibrium point 3, the intersection of the aggregate demand curve AD and the long-run aggregate supply curve at Yn. Here, as in panel (a), the economy comes to rest when output has again returned to the natural rate level.

A striking feature of both panels of Figure 4 is that regardless of where output is initially, it returns eventually to the natural rate level. This feature is described by saying that the economy has a self-correcting mechanism.

An important issue for policymakers is how rapidly this self-correcting mechanism works. Many economists, particularly Keynesians, believe that the self-correcting mechanism takes a long time, so the approach to long-run equilibrium is slow. This

Shifts in

Aggregate

Demand

http://ecedweb.unomaha.edu /Dem_Sup/demand.htm

An interactive tutorial on demand and how various factors cause changes in the demand curve.

view is reflected in KeynesÕs often quoted remark, ÒIn the long run, we are all dead.Ó These economists view the self-correcting mechanism as slow, because wages are inflexible, particularly in the downward direction when unemployment is high. The resulting slow wage and price adjustments mean that the aggregate supply curve does not move quickly to restore the economy to the natural rate of unemployment. Hence when unemployment is high, these economists (called activists) are more likely to see the need for active government policy to restore the economy to full employment.

Other economists, particularly monetarists, believe that wages are sufficiently flexible that the wage and price adjustment process is reasonably rapid. As a result of this flexibility, adjustment of the aggregate supply curve to its long-run position and the economyÕs return to the natural rate levels of output and unemployment will occur quickly. Thus these economists (called nonactivists) see much less need for active government policy to restore the economy to the natural rate levels of output and unemployment when unemployment is high. Indeed, monetarists advocate the use of a rule whereby the money supply or the monetary base grows at a constant rate so as to minimize fluctuations in aggregate demand that might lead to output fluctuations. We will return in Chapter 27 to the debate about whether active government policy to keep the economy near full employment is beneficial.

You are now ready to analyze what happens when the aggregate demand curve shifts. Our discussion of the Keynesian and monetarist views of aggregate demand indicates that six factors can affect the aggregate demand curve: the money supply, government spending, net exports, taxes, consumer optimism, and business optimismÑthe last two (Òanimal spiritsÓ) affecting willingness to spend. The possible effect on the aggregate demand curve of these six factors is summarized in Table 1.

Figure 5 depicts the effect of a rightward shift in the aggregate demand curve caused by an increase in the money supply (M ↑ ), an increase in government spending (G ↑ ), an increase in net exports (NX ↑ ), a decrease in taxes (T↓ ), or an increase in the willingness of consumers and businesses to spend because they become more

F I G U R E 5 Response of Output

and the Price Level to a Shift in the

Aggregate Demand Curve

A shift in the aggregate demand curve from AD1 to AD2 moves the economy from point 1 to point 1 . Because Y1 Yn , the aggregate supply curve begins to shift leftward, eventually reaching AS2, where output returns to Yn and the price level has risen to P2.

Shift in the Aggregate

Demand Curve

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AD2 AD1

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Shifts in

Aggregate Supply

www.census.gov/statab/www/

Statistics on the U.S. economy in an easy-to- understand format.

optimistic (C ↑ , I ↑ ). The figure has been drawn so that initially the economy is in long-run equilibrium at point 1, where the initial aggregate demand curve AD1 intersects the aggregate supply AS1 curve at Yn. When the aggregate demand curve shifts rightward to AD2, the economy moves to point 1 , and both output and the price level rise. However, the economy will not remain at point 1 , because output at Y 1 is above the natural rate level. Wages will rise, eventually shifting the aggregate supply curve leftward to AS2, where it finally comes to rest. The economy thus slides up the aggregate demand curve from point 1 to point 2, which is the point of long-run equilibrium at the intersection of AD2 and Yn. Although the initial short-run effect of the rightward shift in the aggregate demand curve is a rise in both the price level and output, the ultimate long-run effect is only a rise in the price level.

Not only can shifts in aggregate demand be a source of fluctuations in aggregate output (the business cycle), but so can shifts in aggregate supply. Factors that cause the aggregate supply curve to shift are the ones that affect the costs of production: (1) tightness of the labor market, (2) expectations of inflation, (3) workersÕ attempts to push up their real wages, and (4) changes in the production costs that are unrelated to wages (such as energy costs). The first three factors shift the aggregate supply curve by affecting wage costs; the fourth affects other costs of production.

Tightness of the Labor Market. Our analysis of the approach to long-run equilibrium has shown us that when the labor market is tight (Y Yn ) , wages and hence production costs rise, and when the labor market is slack (Y Yn ) , wages and production costs fall. The effects on the aggregate supply curve are as follows: When aggregate output is above the natural rate level, the aggregate supply curve shifts to the left; when aggregate output is below the natural rate level, the aggregate supply curve shifts to the right.

Expected Price Level. Workers and firms care about wages in real terms; that is, in terms of the goods and services that wages can buy. When the price level increases, a worker earning the same nominal wage will be able to buy fewer goods and services. A worker who expects the price level to rise will thus demand a higher nominal wage in order to keep the real wage from falling. For example, if Chuck the Construction Worker expects prices to increase by 5%, he will want a wage increase of at least 5% (more if he thinks he deserves an increase in real wages). Similarly, if ChuckÕs employer knows that the houses he is building will rise in value at the same rate as inflation (5%), his employer will be willing to pay Chuck 5% more. An increase in the expected price level leads to higher wages, which in turn raise the costs of production, lower the profit per unit of output at each price level, and shift the aggregate supply curve to the left (see Figure 2). Therefore, a rise in the expected price level causes the aggregate supply curve to shift to the left; the greater the expected increase in price level (that is, the higher the expected inflation), the larger the shift.

Wage Push. Suppose that Chuck and his fellow construction workers decide to strike and succeed in obtaining higher real wages. This wage push will then raise the costs of production, and the aggregate supply curve will shift leftward. A successful wage push by workers will cause the aggregate supply curve to shift to the left.

Changes in Production Costs Unrelated to Wages. Changes in technology and in the supply of raw materials (called supply shocks) can also shift the aggregate supply curve. A negative supply shock, such as a reduction in the availability of raw materials (like

Study Guide

S U M M A R Y

Factor

Y Yn

Y Yn

Rise in expected price level

C H A P T E R 2 5 Aggregate Demand and Supply Analysis 595

oil), which raises their price, increases production costs and shifts the aggregate supply curve leftward. A positive supply shock, such as unusually good weather that leads to a bountiful harvest and lowers the cost of food, will reduce production costs and shift the aggregate supply curve rightward. Similarly, the development of a new technology that lowers production costs, perhaps by raising worker productivity, can also be considered a positive supply shock that shifts the aggregate supply curve to the right.

The effect on the aggregate supply curve of changes in production costs unrelated to wages can be summarized as follows: A negative supply shock that raises production costs shifts the aggregate supply curve to the left; a positive supply shock that lowers production costs shifts the aggregate supply curve to the right.4

As a study aid, factors that shift the aggregate supply curve are listed in Table 2.

4Developments in the foreign exchange market can also shift the aggregate supply curve by changing domestic production costs. As discussed in more detail in Chapter 19, an increase in the value of the dollar makes foreign goods cheaper in the United States. The decline in prices of foreign goods and hence foreign factors of production lowers U.S. production costs and thus raises the profit per unit of output at each price level in the United States. An increase in the value of the dollar therefore shifts the aggregate supply curve to the right. Conversely, a decline in the value of the dollar, which makes foreign factors of production more expensive, shifts the aggregate supply curve to the left.

Shifts in the

Long-Run

Aggregate Supply

Curve: Real

Business Cycle

Theory and

Hysteresis

www.fgn.unisg.ch/eumacro /IntrTutor/SGEadas.html

Work with an animated interactive AD/AS graph.

Now that we know what factors can affect the aggregate supply curve, we can examine what occurs when they cause the aggregate supply curve to shift leftward, as in Figure 6. Suppose that the economy is initially at the natural rate level of output at point 1 when the aggregate supply curve shifts from AS1 to AS2 because of a negative supply shock (a sharp rise in energy prices, for example). The economy will move from point 1 to point 2, where the price level rises but aggregate output falls. A situation of a rising price level but a falling level of aggregate output, as pictured in Figure 6, has been labeled stagflation (a combination of words stagnation and inflation ). At point 2, output is below the natural rate level, so wages fall and shift the aggregate supply curve back to where it was initially at AS1. The result is that the economy slides down the aggregate demand curve AD1 (assuming that the aggregate demand curve remains in the same position), and the economy returns to the long-run equilibrium at point 1. Although a leftward shift in the aggregate supply curve initially raises the price level and lowers output, the ultimate effect is that output and price level are unchanged (holding the aggregate demand curve constant).

To this point, we have assumed that the natural rate level of output Yn and hence the long-run aggregate supply curve (the vertical line through Yn ) are given. However, over time, the natural rate level of output increases as a result of economic growth. If the productive capacity of the economy is growing at a steady rate of 3% per year, for example, this means that every year, Yn will grow by 3% and the long-run aggregate supply curve at Yn will shift to the right by 3%. To simplify the analysis when Yn grows at a steady rate, Yn and the long-run aggregate supply curve are drawn as fixed in the aggregate demand and supply diagrams. Keep in mind, however, that the level of aggregate output pictured in these diagrams is actually best thought of as the level of aggregate output relative to its normal rate of growth (trend).

The usual assumption when conducting aggregate demand and supply analysis is that shifts in either the aggregate demand or aggregate supply curve have no effect on the natural rate level of output (which grows at a steady rate). Movements of aggregate output around the Yn level in the diagram then describe short-run (business cycle) fluctuations in aggregate output. However, some economists take issue with the assumption that Yn is unaffected by aggregate demand and supply shocks.

F I G U R E 6 Response of Output

and the Price Level to a Shift in

Aggregate Supply

A shift in the aggregate supply curve from AS1 to AS2 moves the economy from point 1 to point 2. Because Y2 Yn , the aggregate supply curve begins to shift back to the right, eventually returning to AS1, where the economy is again at point 1.