Chapter 14 -- Aggregate Supply and Economic Growth

This chapter -- looks at the effects of changes in Aggregate Supply, both short-run and long-run.

Correspondingly, we examine the causes that shift the AS curve and the LAS curve, and their effects on the economy.

Short-Run Aggregate Supply (AS)

Short-Run Aggregate Supply (AS) -- the sum of all the newly produced US final goods and services that firms wish to produce (real GDP supplied), given inflexible input prices (especially the nominal wage rate).

Short-Run Aggregate Supply (AS) -- Causes

Price Level (P)

P ASPrice of Energy (PE)

PE ASThe Nominal Wage Rate (W)

W AS

Short-Run Aggregate Supply -- More Causes

Labor Productivity (PROD), defined as output per labor hour.

PROD ASCapital Stock (K) -- all the existing

physical plant and equipment used by firms to produce goods and services.

K AS

Formalizing the AS Curve

Upward sloping when graphed against Price Level (P).

Changes in a cause other than P -- described as shifting the AS curve.

Changes in variables that increase AS, or enhance production, shift the AS curve rightward.

Changes in variables that decrease AS, or hinder production, shift the AS curve leftward.

Example 1 -- A Supply Shock

Example 1 -- The price of energy (PE) increases (energy crisis in US, 1973 and 1979).

PE hinders production, reduces Short-Run Aggregate Supply.

Therefore the AS curve shifts leftward.As a result, Y*, P* (Yuck!!).

Example 2 -- Productivity: The “Magic” Variable

Example 2 -- Labor productivity (PROD) increases (late 1990s, 2000 in US).

PROD increases Short-Run Aggregate Supply.

Therefore the AS curve shifts rightward.

As a result, Y*, P* (Wow!!).

Example 3 -- The Wage-Price Spiral

Example 3 -- Two Changes. (1) Increases in (G - T) (increase in government purchases, or decrease

in taxes) move Y* beyond YF and accelerate inflation. (2) Labor wants their wages to keep pace with inflation, so they get larger than normal wage increases (W).

Describing The Wage-Price Spiral -- AD-AS Model

(1) Increase in (G - T) shifts AD curve

rightward, Y* beyond YF, P*.(2) The rise in W is described by a shift of the AS curve leftward.

As a result Y* returns to its previous level, P* even more.

Creates a situation called Stagflation – inflation with stagnant output.

Tends to be a continuing process, i.e. “spiral”.

The Long-Run Aggregate Supply (LAS) Curve

Vertical when plotted versus the price level (P).

Vertical at the full sustainable level of real GDP (YF)

Shifting the LAS Curve

Curve shifts either rightward (increase in LAS) or leftward (decrease in LAS)

Variables that shift the LAS curve rightward, therefore, increase YF.

Variables that shift the LAS curve leftward, therefore, decrease YF.

Shift Variables – LAS Curve (Variables That Change YF)

Labor Productivity (PROD) PROD LAS

Capital Stock (K) -- all the existing plant and equipment used by firms to produce goods and services.

K LAS

More Shifters – LAS Curve (Variables That Change YF)

Size of Labor Force

Labor Force LASTastes/Preferences Toward Work.

Work LASTransfer Payments (TP)

TP LAS

Application #1 – What Makes YF Grow in the US?

Steady Growth in the Following Variables: Labor Force Capital Stock Accumulation Labor Productivity

Average Growth of YF in US: 2.5% per year

Not the same for all countries in the world.

Application #2 – Effects of a Productivity Boom

Suppose that increased technology (e.g. computerization) makes labor more productive.

Productivity growth increases, shifts LAS curve rightward more than usual.

Application #2 Continued -- Effects on YF

Therefore YF in the US grows at more than 2.5%.

This implies that actual real GDP (Y*) can enjoy higher growth without accelerating inflation.

Very nice!!

Goals for the Economy

Fluctuations -- seek to get the economy (Y*) as close to possible to a given YF (examples: standard fiscal and monetary policy) shift AD curve.

Economic Growth -- seek to increase the full sustainable level of real GDP (YF) shift LAS curve.

Ways to Increase Economic Growth (Increase YF)

Capital StockLabor ProductivityLabor ForceHousehold Attitudes Toward

WorkTransfer Payments

Trying to Increase Labor Productivity

Increase Research and Development.Increase Labor Quality (Human Capital)

– Education and Vocational Training.Promote Investment (plant and

equipment)!!! -- Tends to Incorporate New Technology. -- Also expands the capital stock.