Chapter 13 Aggregate Supply and the Equilibrium Price Level The Aggregate Supply Curve Aggregate supply the total supply of all goods and services in an economy Aggregate supply AS curve a graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level not a market supply curve not a sum of all the individual supply curves in the economy Short run aggregate supply curve has a positive slope for low levels of aggregate output income the aggregate supply curve is fairly flat for high levels of aggregate output income the aggregate supply curve is vertical o Upward sloping curve can be due to the assumption that wages are a large fraction of total costs and that wage changes lag behind price changes Shifts of the short run aggregate supply curve o Rightward shift indicates that society can get a larger aggregate output at a given price level caused by an increase in labor or capital or energy o Cost shock supply shock a change in costs that shifts the short run aggregate supply curve The Equilibrium Price Level Equilibrium price level the price level at which the aggregate demand and Each point on the AD curve corresponds to equilibrium in both the goods Each point on the AS curve represents the price output responses of all the aggregate supply curves intersect market and the money market firms in the economy The Long Run Aggregate Supply Curve If wages fully adjust to prices in the long run then the long run AS curve will be vertical Vertical AS curve exists bc there are physical limits to the amount that an economy can produce in any given time period Potential output potential GDP the level of aggregate output that can be sustained in the long run without inflation If the short run aggregate supply and aggregate demand curves intersect to the right of Y0 wages will rise causing the short run AS curve to shift to the left and pushing aggregate output back down to Y0 output will fall If the short run aggregate supply and aggregate demand curves intersect to the left of Y0 wages will decrease causing the AS curve to shift to the right and the level of aggregate output to rise back to Y0 output will rise Monetary and Fiscal Policy Effects Fiscal policy variables government purchases and net taxes Monetary policy variable quantity of money supplied If the economy is initially on the flat portion of the AS curve an expansionary policy which shifts the AD curve to the right will result in a small price increase relative to the output increase the increase in equilibrium Y is much greater than the increase in equilibrium P works well Increase in output with little increase in price level If the economy is initially on the steep portion of the AS curve an expansionary policy will result in a small increase in equilibrium output and a large increase in the equilibrium price level expansionary policy does not work well much higher price level with little increase in output AS curve is vertical in the long run so neither monetary policy nor fiscal policy has any effect on aggregate output in the long run Causes of Inflation demand Demand pull inflation inflation that is initiated by an increase in aggregate Cost push or supply side inflation inflation caused by an increase in costs o An increase in costs shifts the AS curve to the left AD curve will not shift if government does not react by changing fiscal or monetary policy supply shift will cause the equilibrium price level to rise level of aggregate output to decline o Stagflation occurs when output is falling at the same time that prices are rising o Government could counteract the increase in costs by engaging in an expansionary policy this would shift the AD curve to the right and the new AD curve would intersect he new AS curve at a higher level of output problem is that this intersection takes place at a very high price Expectations o Optimal price the price that maximizes the firm s profits is not too far from the average of its competitors prices Increase in gov spending G with the money supply unchanged shifts the AD curve to the right results in a higher price level Higher price level causes the demand for money to increase but with an unchanged money supply and an increase in the quantity of money demanded the interest rate will rise which results in a decrease in planned investment G increases Fed increases money supply to keep interest rate constant Supply of money expanded AD curve shifts to the right pushes prices up higher prices causes a demand for money further which requires a further increase in the money supply and so on Many believe that an increase in the price level can be caused by anything that causes the AD curve to shift to the right or the AS curve to shift to the left Sustained inflation can be thought of as a purely monetary phenomenon The Behavior of the Fed The Fed targets the interest rate rather than the money supply The interest rate value that the Fed choses depends on the state of the economy o If the economy is in a low output low inflation situation it will be producing on the relatively flat portion of the AS curve Fed can increase output by lowering the interest rate and thus increasing the money supply with little effect on the price level expansionary monetary supply will shift the AD curve to the right leading to an increase in output with little change in the price level o Economy high output high inflation economy is producing on the relatively steep portion of the AS curve Fed can increase the interest rate and thus decrease the money supply with little effect on output Contractionary monetary policy will shift the AD curve to the left which will lead to a fall in the price level and little effect on output o Stagflation if the Fed lowers the interest rate output will rise but so will the inflation rise which is already too high if the Fed increases the interest rate the inflation rate will fall but so will output which is already too low Fed generally had high interest rates in the 1970s and early 1980s as it fought inflation since 1983 inflation has been low by historical standards and the Fed focused in this period of trying to smooth fluctuations in output Inflation targeting when a monetary authority chooses its interest rate value with the aim of keeping the inflation rate within some specified band over some specified horizon
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