Aggregate SupplyAD/AS Model Continued

Aggregate Supply Curve• Aggregate-supply curve (AS)- how supply of goods &

services for the entire economy changes with inflation– quantity of goods & services all firms produce at each price level

AS1PriceLevel

RealGDP

AD1

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P1

Y1

E1

Gov’t ↓ Taxes => consumer income ↑

C ↑ => AD ↑ => R-GDP ↑

AD2

AD = C + I + G + NX

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P2

Y2

E2

AS

PxLevel

Real GDP

ASPxLevel

Real GDP

ASPxLevel

Real GDP

Different Shapes of AS CurvesWorksheet

Aggregate Supply Curve• Aggregate-supply curve (AS)- how supply of goods &

services for the entire economy changes with inflation

• Short run curve (SRAS) is upward sloping

• Long Run curve (LRAS) is vertical

Determinants of Real GDP

• In long run, economy’s output depends on quantity of:– Labor– Capital, – Natural resources – Technology

• In long run, Price level does not affect these variables

Price Level is related only toQuantity of Money

Natural Rate of Output

• Definition: Level of Real GDP economy achieves in long run at full-employment (full potential output)

– LRAS is vertical at level of “natural rate of output”

Also called: Full potential output or Full-employment output

Qty

Food

Qty

Shelter

. B

. A

. C

(100, 0)

(0,100)

(50,50)

(100, 0)

(0,100)

(50,50)

Conditions: On PPF curve & at full employment

Long-Run AS Curve

Real GDPNatural rateof output

PriceLevel

0

LRAS

P2

A change inprice level

Does NOT affect Qty of goods/services supplied

P

Inflation Doubles:

Real OutputDoes NOTChange!

Full Employment Output

Why is the Short Run AS Curve upward sloping?

• 2 Primary Theories:– Sticky-Wage Theory– Sticky-Price Theory– (you can ignore 3rd theory in Textbook— misperceptions theory)

Real GDP

PriceLevel

0

Aggregatesupply

Aggregatesupply

Aggregatedemand

Aggregatedemand

Equilibriumoutput

Equilibriumprice level

Equilibriumoutput

Equilibriumprice level

SRAS1

AD1

Y

P1

Sticky-Wage Theory

• Nominal wages are slow to adjust to changing economic conditions– Wages are “sticky” in short run

• Example: Price level falls => Nominal wages do not adjust immediately – Production is now less profitable because wages are artificially high

– So firms reduce quantity of goods & services supplied

Real GDP

PriceLevel

0

Aggregatesupply

Aggregatesupply

Aggregatedemand

Aggregatedemand

Equilibriumoutput

Equilibriumprice level

Equilibriumoutput

Equilibriumprice level

SRAS1

AD1

Y

P1

Business sign 2-year contract to pay Workers $20/ hour

Price LevelSuddenly rises

Wages are cheapin “real dollars”Firm will increase supply

Sticky Wages in Action

Real GDP

PriceLevel

0

Aggregatesupply

Aggregatesupply

Aggregatedemand

Aggregatedemand

Equilibriumoutput

Equilibriumprice level

Equilibriumoutput

Equilibriumprice level

SRAS1

AD1

Y

P1

Sticky Price Theory

• Prices of some goods & services adjust sluggishly in response to changing economic conditions

• An unexpected fall in price level leaves some firms with higher-than-desired prices– This depresses sales, which induces firms to supply less

AS/AD Model Review

LRAS1PriceLevel

RealGDP

AD1

SRAS1

P1

Y1

E1-----------------