Module 28(64) Aggregate Supply. Module Objectives. Module Outline. I. The Aggregate Supply Curve

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1 Module 28(64) Aggregate Supply Module Objectives What students will learn: How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy What factors can shift the aggregate supply curve Why the short-run aggregate supply curve is different from the long-run aggregate supply curve Module Outline I. The Aggregate Supply Curve A. Definition: The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied. B. The short-run aggregate supply curve 1. Definition: The nominal wage is the dollar amount of the wage paid. 2. Definition: Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. 3. A firm s profit per unit of output is equal to the price per unit of output minus the production cost per unit of output. 4. Perfectly competitive firms are price takers. If market price falls, they will reduce output. This is because many production costs are fixed, so profit per unit will fall. 5. Imperfectly competitive firms have some pricing power. When demand rises, these firms can increase price and therefore increase profit per unit. When demand falls, they will lower price to preserve sales. 6. Definition: The short-run aggregate supply (SRAS) curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the short run, the period when many production costs can be taken as fixed. 7. During the Great Depression, the economy moved down the short-run aggregate supply curve, with deflation causing the quantity of aggregate output supplied to decrease. 134

2 module 28(64) aggregate supply 135 C. Shifts of the short-run aggregate supply curve 1. Short-run aggregate supply increases when producers increase the quantity of aggregate output they are willing to supply at any given price level. 2. An increase in short-run aggregate supply is demonstrated by a rightward shift of the short-run aggregate supply curve. 3. Short-run aggregate supply decreases when producers decrease the quantity of aggregate output they are willing to supply at any given price level. 4. A decrease in short-run aggregate supply is demonstrated by a leftward shift of the short-run aggregate supply curve. 5. The short-run aggregate supply curve shifts when there is a change in: a. commodity prices. b. nominal wages. c. productivity. D. The long-run aggregate supply curve 1. Definition: The long-run aggregate supply (LRAS) curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. 2. The long-run aggregate supply curve, LRAS, is vertical because changes in the aggregate price level have no effect on aggregate output in the long run. 3. Definition: Potential output is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. 4. The long-run aggregate supply curve is vertical at the level of potential output, as shown in Figure 28-3 in the text. 5. U.S. potential output has risen over time as a result of increases in the size of the labor force, increases in physical and human capital, and technological progress. 6. As the economy grows in the long run, potential output rises and the long-run aggregate supply curve shifts to the right. E. From the short run to the long run 1. At any point in time, the economy is operating either on a short-run aggregate supply curve or on the long-run aggregate supply curve. 2. It is possible for the economy to be operating on both aggregate supply curves simultaneously by being at that level of output where the short-run aggregate supply curve and the long-run aggregate supply curve intersect. 3. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment, and aggregate output will fall, represented by a leftward shift of the short-run aggregate supply curve. This adjustment process is shown in panel (a) in Figure 28-5 in the text.

3 136 module 28(64) aggregate supply Aggregate price level (a) Leftward Shift of the Short-run Aggregate Supply Curve LRAS SRAS 2 SRAS 1 P 1 A 1 A rise in nominal wages shifts SRAS leftward. Y P Y 1 Real GDP 4. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment, and aggregate output will rise, represented by a rightward shift of the short-run aggregate supply curve. This adjustment process is shown in panel (b) in Figure 28-5 in the text. Aggregate price level (b) Rightward Shift of the Short-run Aggregate Supply Curve LRAS SRAS 1 SRAS 2 P 1 A 1 A fall in nominal wages shifts SRAS rightward. Y 1 Y P Real GDP Teaching Tips The Aggregate Supply Curve Creating Student Interest Ask students how they think a firm decides what price to charge. They may say the firm wants to maximize profit, or they may say the firm wants to charge a price that at least covers its cost of production. From here you can discuss the idea that an increase in production cost will lead firms to increase price. Next ask students if all firms can increase the price of output if they want to. Beyond the obvious of course they do, because it

4 module 28(64) aggregate supply 137 is their decision, remind students that some firms operate in perfectly competitive markets and some do not. Finally, ask students how often they think workers receive an increase (or decrease) in wages. They should realize that this is not very often. Thinking about the firm s production cost and how this is related to the price it charges will help students understand the short-run aggregate supply curve. Presenting the Material Make sure students understand that the aggregate supply curve represents the behavior of the firms. When demand increases, some firms can increase price immediately, even though their costs of production may not change. This causes the short-run aggregate supply curve to slope upward. You may have to review the concept of profit per unit of output and the difference between a perfectly competitive firm and an imperfectly competitive firm. To explain the difference between short-run and long-run aggregate supply, remind students that there is a difference between potential output and actual output. Potential output is defined by the economy s capacity to produce, as determined by the size and productivity of the labor force. Actual output fluctuates in response to aggregate demand. In the long run, when prices and wages are fully flexible, actual output is equal to potential output. As with aggregate demand, take time to explain the factors that cause the short-run aggregate supply curve to shift. In particular, explain what happens when the economy is on the short-run aggregate supply curve but not the long-run aggregate supply curve: wages will adjust and the short-run aggregate supply curve will shift. For example, if nominal wages rise, then production cost will rise, and firms will want to increase price so that profit per unit of output does not fall. The short-run aggregate supply curve shifts up and to the left. Common Student Pitfalls The long run and the short run. It s important to emphasize to students that the long-run period referred to in this module with respect to long-run aggregate supply is the same period that was analyzed in the context of long-run economic growth. Both concepts relate to an extended period during which the economy s rate of economic growth will correspond to the rate of growth of potential output in the economy in the long run. Case Studies in the Text Economics in Action Prices and Output During the Great Depression This EIA uses historical data from 1929 to 1942 to illustrate a shift in the short-run aggregate supply curve. Ask students the following questions: 1. Describe the movement along the economy s short-run aggregate supply curve during the period (Answer: the economy was moving down along the short-run aggregate supply curve during this period, as both aggregate output and the aggregate price level fell.) 2. Describe the movement along the economy s short-run aggregate supply curve during the period (Answer: the economy was moving

5 138 module 28(64) aggregate supply up along the short-run aggregate supply curve during this period, as both aggregate output and the aggregate price level rose.) 3. Over the period , how did the short-run aggregate supply curve shift, and why did it shift? (Answer: over the period , the short-run aggregate supply curve shifted to the right due to technological progress during this time.) Activities Which Way Does SRAS Shift? (15 minutes) Ask students to work in pairs to determine the effect on the short-run aggregate supply (SRAS) curve for each of the following scenarios. Also ask students to demonstrate their graphical analysis in each case. Remind students to accurately label all lines, points, and axes when drawing the graphs for these exercises. 1. Labor productivity increases in the macroeconomy. (Answer: the SRAS curve will shift to the right.) 2. An earthquake destroys a significant amount of infrastructure. (Answer: the SRAS curve will shift to the left.) 3. Technological progress occurs. (Answer: the SRAS curve will shift to the right.) Understanding LRAS (10 minutes) Pair students and ask them to answer the following thought questions. 1. Why is the LRAS curve vertical? (Answer: The LRAS curve is vertical because despite any changes in the aggregate price level, aggregate output cannot change from its fixed level, known as potential output. This is because all prices, including nominal wages, are fully flexible in the long run.) 2. Can the LRAS curve shift? (Answer: long-run economic growth allows the level of potential output to increase over time, resulting in a rightward shift of the LRAS.)