Foundations of aggregate supply

Recall:
• Aggregate supply
-Describes the behavior of the production side of
the economy
-Total quantity of goods and services that
businesses willingly produced and sell in a given
period.

Aggregate supply Curve/ AS Curve

-schedule showing the level of total national
output that will be produced at each price level
 Recall:
• Short-run AS schedule
-not more than a decade
-upward sloping
-higher prices are associated with increase in
the production of goods and services

Long-run AS Schedule
-period of several years or a decade more
-vertical AS schedule
-increase in the price level are not associated
with an increase in total output supplied
 Determinants of Aggregate supply
• Potential Output (Potential GDP)
-maximum sustainable output that can be
produce without triggering rising inflation
-highest sustainable level of national output
-the output that would be produced at a target
level of the unemployment rate called
nonaccelerating inflation rate of unemployment.

Input(land, labor, capital)

Technology and Efficiency
 Determinants of Aggregate supply
Potential Output IS NOT Maximum Output

Maximum sustainable output but not

the absolute maximum output that an
economy can produce Analogy: Someone Running a Marathon

“Think of potential output as the maximum

speed that a marathoner can run without
being overheated and dropping out of
exhaustion.”
 a. Increase in potential output
Potential output

AS AS’
Price level

Q
QP QP’
Real output
 Determinants of Aggregate supply
• Input Costs
Wages
-lower wages lead to lower production costs
-lower costs means that quantity supplied will be
higher at every price level for a given potential output

Import Prices
-decline in foreign prices or an appreciation in the
exchange rate reduces import prices. This leads to
lower production costs and raises aggregate supply.
Determinants of Aggregate supply
Other Input Costs
Lower oil prices or less burdensome environmental
regulations lowers production costs and thereby raises
aggregate supply
 b. Increase in costs
Potential output AS’’

AS
Price level

Q
Real Output
QP
 Aggregate supply and potential output
P
2
AS curve
for 2000
Price level (1996=100)

AS curve
for 1982

Q
2,ooo 4,ooo 6,ooo 8,ooo

Real GDP(billions, 1996 prices)

Aggregate Supply in the Short
Run and Long Run
 Views in looking at Aggregate Supply
• Keynesian – upward-sloping; indicates that
firms are willing to increase their output levels
in response to changes in aggregate demand,
particularly when there is a slack in the
economy.
• Classical Approach– the level of output
supplied is independent of aggregate demand.
 During Short-runs…
• Some elements of business are inflexible or
sticky.
• As a result of this inflexibility, business can
profit from higher levels of aggregate demand
by producing more output.
 Price Level
P

Potential Output

Real Output
Qp
AS

Q
 Example!
• Wages
– Wages adjust slowly when economic conditions
change for a number of reasons.
– Workers are less likely to get an increase in their
wages more than once a year.
– So firms can adjust the production to suit the
aggregate demand.
 However, during long-runs…
• Eventually, the inflexible or sticky elements of
costs—wage contracts, rent agreements,
regulated prices, and so forth—become unstuck
and negotiable.
• In the long-run, after all elements of cost have
fully adjusted, firms will face the same ratio of
price to costs as they did before the change in
demand.
• The long-run AS curve therefore tends to be
vertical, which means that output supplied is
independent of the levels of prices and costs
 Price Level
P

Potential Output

Real Output
Qp
Q
UNEMPLOYMENT
 TERMS
• Employed
– People who perform paid work
• Unemployed
– People who currently have no work but are
willing and able to work
• Labor Force
– All people who are employed and unemployed
 TERMS
• Unemployment rate
– The number of unemployed divided by the total
labor force
 IMPACT OF UNEMPLOYMENT
• Economic Impact

“When unemployment goes up, the G&S that the

unemployed workers could have produced are in
effect as if being thrown away.”

• Social Impact
 OKUN’S LAW
 The most distressing consequence of recession is the rise of a
unemployment rate.
 Okun’s Law states the for every 2 percent that GDP falls
relative to the potential GDP, the unemployment rate rises
about 1 percentage point.
 Unemployment usually moves inversely with output over the
business cycle.
 This co-movement was first identified by Arthur Okun.
 According to Okun’s Law, whenever output grows 2 percent faster
than potential GDP, the unemployment rate declines 1 percentage
point.
 Unemployment changes are well predicted by the rate of GDP
growth.
 One important consequence of Okun’s Law is that actual GDP must
grow rapidly as potential GDP just to keep the unemployment rate
from rising.
 In sense, GDP has to keep running just to keep unemployment in
the same place. Moreover, if you want to bring the unemployment
rate down, actual GDP must be growing faster then potential GDP.
 Okun’s Law provides the vital link between the output market and
the labor market. It describes the association between short-run
movements in real GDP and changes in unemployment.
Economic Interpretation of
Unemployment
Maguad, John Albert T.
2009-21425
• What are the reasons for being unemployed?

• What is the distinction between voluntary and

involuntary unemployment?
Three Kinds of Unemployment

• Frictional Unemployment

• Structural Unemployment

• Cyclical Unemployment
 Frictional Unemployment

• Arises because of the incessant movement of

people between regions and jobs or through
different stages of the life cycle.

• Frictionally unemployed workers are often

moving between jobs or looking for better
jobs.
 Structural Unemployment

• Signifies a mismatch between the supply of

and the demand for workers.

• We often see structural imbalances across

occupations or regions as certain sectors grow
while others decline.
 Cyclical Unemployment

• Exists when the overall demand for labor is

low.

• As total spending and output fall,

unemployment rises virtually everywhere.
Voluntary and Involuntary
Unemployment
 Sources of Wage Inflexibility
• Why do wages not move up or down to clear
markets?

• Auction Markets
• Administered Markets
Labor Market Issues
Duration of unemployment
Sources of joblessness
1982 2000
Job loser 5.7 1.8
Reentrant 2.2 1.3
New 1.1 0.3
entrant

Job leaver 0.8 0.5

Unemployment by age
Age White Black
16-17 15.2 31.1
18-19 11.1 27.6
20-24 6.9 16.2
25-34 4.1 8.1
35-44 3.2 6.4
45-54 2.8 4.8
55-64 2.9 3.9
65-69 2.9 4.8
70-74 2.8 3.1
Over 75 2.8 3.3
Philippines
Youth unemployment

2009 17.4
2008 17.5
2007 14.9
2006 16.9
2005 16.4
2004 21.7
2003 20.1
2002 21.4
2001 19.0
2000 21.2