Aggregate Supply and the Role of Money

Unit-V

Aggregate Supply and the Role of Money

Introduction:

The aggregate supply curve depicts the quantity of real GDP that is supplied by the economy at different price levels. The reasoning used to construct the aggregate supply curve differs from the reasoning used to construct the supply curves for individual goods and services. The supply curve for an individual good is drawn under the assumption that input prices remain constant. As the price of good X rises, sellers' per unit costs of providing good X do not change, and so sellers are willing to supply more of good X-hence, the upward slope of the supply curve for good X. The aggregate supply curve, however, is defined in terms of the price level. Increases in the price level will increase the price that producers can get for their products and thus induce more output. But an increase in the price will also have a second effect; it will eventually lead to increases in input prices as well, which, ceteris paribus, will cause producers to cut back. So, there is some uncertainty as to whether the economy will supply more real GDP as the price level rises. In order to address this issue, it has become customary to distinguish between two types of aggregate supply curves, the short-run aggregate supply curve and the long-run aggregate supply curve.

A definition of aggregate supply

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, aggregate supply represents the ability of an economy to produce goods and services either in the short-term or in the long-term. It tells us the quantity of real GDP that will be supplied at various price levels. The nature of this relationship will differ between the long run and the short run

·  In the long run, the aggregate-supply curve is assumed to be vertical

·  In the short run, the aggregate-supply curve is assumed to be upward sloping

Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are assumed to be held constant.

The short run is characterized by inflexible prices and disequilibrium in resource markets, either surplus or shortage. This means that resources, especially labor, have either cyclical unemployment or over employment. Inflexible prices mean that real production is responsive to the price level. A higher price level induces an increase in real production, as employment increases, and a lower price level induces a decrease in real production, as employment decreases. As a result, the short-run aggregate supply curve is positively sloped

Long run aggregate supply (LRAS): In the long run all prices are flexible. Price flexibility ensures that all markets are in equilibrium. Prices rise to eliminate market shortages and fall to eliminate market surpluses. The end result is equilibrium--FOR ALL MARKETS. This conclusion is particularly important for resource markets, especially labor. No surplus in the labor market, means that no workers are seeking jobs that do not exist. There is no cyclical unemployment. And no cyclical unemployment means full employment. The long run is characterized by both flexible prices and full employment.

The long run is characterized by flexible prices and equilibrium in production, financial, and resource markets. This means that resources, especially labor, have full employment. Flexible prices mean that full employment is achieved and maintained, regardless of the price level. As a result, the long-run aggregate supply curve is vertical at the quantity of real production generated at full employment.

Determinants of Aggregate supply:

A wide variety of specific factors can cause the aggregate supply curves to shift, they are commonly grouped into three broad categories--resource quantity, resource quality, and resource price. Changes in any of the aggregate supply determinants cause the short-run and/or long-run aggregate supply curves to shift.

The assortment of aggregate supply determinants fall into three categories

(1) Resource quantity--the amounts of labor, capital, land, and entrepreneurship available,

(2) Resource quality--the productivity of the four factors of production, and

(3) Resource price--the prices of the inputs used in production.

1.  Resource Quantity: The first major determinant is the quantity of resources--labor, capital, land, and entrepreneurship--that the economy has available for production. This determinant causes shifts of both the SRAS and LRAS curves. Quite simply, if the economy has more resources, then aggregate supply increases and both aggregate supply curves shift rightward. With fewer resources, aggregate supply decreases and both curves shift leftward.

Some of the specific determinants that can cause changes in resource quantity include:

·  Population: The total size of the population, which is affected by births, deaths, and migration, is a key influence on the quantity of labor. A larger population means more potential workers. While population generally increases through both natural growth and immigration, it can decrease as well. Reasons for a declining population including emigration, wars, famines, diseases, and natural disasters.

·  Labor Force Participation Rate: The labor force participation rate is another key influence on the labor quantity. A change in the proportion of a given population that is willing and able to work changes the labor force and shifts the aggregate supply curves. The U.S. economy, for example, has seen an increase in its labor force participation rate over the last 50 years largely through an increase in the proportion of women in the labor force.

·  Capital Stock: Changes in the economy's stock of capital is the most important influence on the quantity of capital. These changes are brought about through a combination of investment and depreciation. Investment adds to the capital stock and depreciation reduces it. Investment has the curious role of affecting both the aggregate demand curve, as one of the four aggregate expenditures, and the aggregate supply curves, by influencing the capital stock.

·  Exploration: Discovering new sources of raw materials or other natural resources influences the quantity of land. While the economy is unlikely to "discover" large masses of land like explorers did a few centuries back, exploration does identify mineral deposits, fossil fuel reserves, and other natural resources that increases the aggregate supply curves. Alternatively, depletion of existing natural resources causes a decrease in the aggregate supply curves.

2.  Resource Quality: The second major determinant of the aggregate supply curves is the quality of resources. If the quality of labor, capital, land, and entrepreneurship changes, then the SRAS and LRAS curves shift. An improved quality increases aggregate supply and a decline in quality decreases aggregate supply.

Two specific determinants that affect resource quality are education and technology.

·  Education: Education includes formal, college-type, get-a-degree education, and informal on-the-job training and learn-by-doing experiences. Education affects the quality of labor. Higher quality labor, brought about by more education, is more productive and causes the aggregate supply curves to increase. Of course, it is also possible for less education to reduce the quality of labor and cause the aggregate supply curves to decrease.

·  Technology: Technology is the information that the economy has concerning production techniques. Technology generally affects the quality of capital, but can also peripherally affect the quality of labor, land, and entrepreneurship. In modern times, technology has invariably advanced, causing increases in the quality of capital and thus increases in aggregate supply. It is, however, possible for a technological back step that would cause a decrease in the quality of capital and aggregate supply.

3.  Resource Price: The third major aggregate supply determinant is resource price. The prices of resource affect the cost of producing output and thus the price level charged for an existing quantity of real production. This determinant ONLY affects the short-run aggregate supply. Because the long-run aggregate supply is independent of the price level it is also unaffected by changes in resource prices and production cost.

Two of the more important resource prices that influence production cost and shift the SRAS curve are:

·  Wages: Wage payments to labor are usually at the top of any list of resource prices. Wages account for about 60 percent of production cost of the economy. Economy-wide changes in wages shift the SRAS curve. Higher wages, by increasing production cost, cause a decrease short-run aggregate supply. Lower wages, by decreasing production cost, cause an increase short-run aggregate supply.

·  Energy Prices: Energy prices, especially petroleum prices, are a second key group of resource prices. Because energy, like labor, is critical in the production of virtually every good and service in the economy, changes in energy prices also tend to shift the SRAS curve. Like wages, higher energy prices increase production cost and cause a decrease short-run aggregate supply. Lower energy prices decrease production cost and cause an increase short-run aggregate supply.

Aggregate supply determinants are held constant when the aggregate supply curves are constructed. A change in any of these determinants causes a shift of the short-run aggregate supply curve, the long-run aggregate supply curve, or both.

Short run and long run supply curve:

The aggregate supply determinants shift the short-run aggregate supply curve, abbreviated SRAS, and the long-run aggregate supply curve, abbreviated LRAS. The exhibit to the right presents a standard short-run aggregate supply curve in the top panel and a typical long-run aggregate supply curve in the bottom panel.

The short-run aggregate supply curve is positively sloped and captures the specific one-to-one relationship between the price level and real production Shifting the Aggregate Supply Curves: Consider first the short-run aggregate supply curve. An increase in short-run aggregate supply is illustrated by a rightward shift in the SRAS curve in the top panel. A decrease in short-run aggregate supply is illustrated by a leftward shift

Shifts in the Long run supply curve:

The long-run aggregate supply curve is vertical at the full-employment level of production, indicating that real production is independent of the price level.

Long-Run Aggregate Supply: Now consider the long-run aggregate supply curve. An increase in long-run aggregate supply is illustrated by a rightward shift in the LRAS curve in the bottom panel. A decrease in long-run aggregate supply is illustrated by a leftward shift.

What does it mean to have an increase in supply? It means that for every price level, the business sector is willing and able to supply more real production. A decrease in supply is obviously the exact opposite. For every price level, the business sector is willing and able to supply less real production.

Two Changes

Shifts of the short-run or long-run aggregate supply curve, brought about by such things as education or technology, an increase in the size of the population or the capital stock, or changes in wages or energy prices, can be the source of disequilibrium in the aggregate market. Such disequilibrium then results in changes in the price level. The key is that aggregate supply determinants CAUSE shifts of the aggregate supply curves which CAUSE disequilibrium which then CAUSES changes in the price level.

This suggests an important difference between two related changes--a change in aggregate supply and a change in real production.

·  A change in aggregate supply is any shift of either of the aggregate supply curves. With this change, the entire curve shifts to a new location. A change in aggregate supply is caused by a change in the aggregate supply determinants. This is comparable to a change in supply in the analysis of the market.

·  A change in real production is a movement along a given aggregate supply curve. This change involves the movement from one point on the existing curve to another point on the SAME curve. The curve does not move. A change in real production is caused by a change in the price level, and ONLY a change in the price level! This is comparable to a change in quantity supplied in the analysis of the market.

While a change in real production, as a movement along the curve, applies in principle to both short-run and long-run aggregate supply curves, because real production does not change in the long run, from a practical standpoint, a change in real production primarily applies to the short-run aggregate supply curve.

AGGREGATE SUPPLY DECREASE, LONG-RUN AGGREGATE MARKET:

A shock to the long-run aggregate market caused by a decrease in aggregate supply, resulting in and illustrated by a leftward shift of the long-run aggregate supply curve. A decrease in aggregate supply in the long-run aggregate market results in an increase in the price level and a decrease in real production. The level of real production resulting from the shock is a smaller level of full-employment real production.

While a wide range of specific aggregate supply determinants can cause a decrease in aggregate supply, the following rank among the more important:

Ø  A decline in the size of the population or a decrease in the labor force participation rate, both of which decrease the quantity of labor available for production.

Ø  Depreciation of capital goods, which decreases the quantity of capital available for production.

Ø  The depletion of existing mineral deposits or fossil fuels, both of which decrease the quantity of land resources available for production.

Ø  A decrease in education which decreases the quality of labor resources.

Ø  A decrease in technology which decreases the quality of capital resources.

The long-run aggregate market presented in the graph to the right sets the stage for analyzing the effect of a decrease in aggregate supply resulting from a change in an aggregate supply determinant. The vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). The negatively-sloped curve, labeled AD, is the aggregate demand curve and the vertical curve, labeled LRAS, is the long-run aggregate supply curve. The current long-run equilibrium, found at the intersection of the AD and LRAS curves, is a price level of 10 and real production of $100 billion. This equilibrium level of real production is also full-employment real production.