2. Aggregate Supply
 Aggregate supply is the relationship between the price level in the
economy and the quantity of aggregate output firms are willing
and able to supply, other things held constant
 The foundation of aggregate supply is the labor market
 Like any market, the labor market has a demand side and a supply side
 A good understanding of aggregate supply requires a correct
understanding of the demand and supply sides of the labor market

3. The Aggregate Supply Curve:
A Warning
The aggregate supply curve is not
a market supply curve or the sum
of all the individual supply curves
in the economy.

4.  The Aggregate Supply (AS) curve is an important tool in analysing
the macroeconomy. Its shape describes whether and by how
much an economy can increase output.
 The curve is built from and affected by some of the main
macroeconomic building blocks such as wages, labour and
prices and production function.
 The curve can be used to analyses the effect of changes in these
on the economy as a whole, and to examine the impact of shocks
such as oil shocks. Both long and short run effects need to be
considered.
 A detailed understanding is required to understand the shape of
AS CURVE

5. The Aggregate Supply curve is derived ultimately from the short run aggregate
production function.
A production function is a mathematical relationship between inputs and outputs.
At the macroeconomic level, the aggregate production function shows the
relationship between Gross Domestic Product, GDP (Y), and various
macroeconomic inputs. The most important of these are the hours of labour
employed (N) and the units of capital employed (K), all though others such as
the price of oil or technology may be relevant if these change. This then gives a
production function:
Y=
f(N,K)
where f is the aggregate production function. Note that Y always
increases if one of the inputs increases (monotonically
increasing). Increasing all units by an equal proportion (e.g.
doubling) will increase Y by the same proportion (constant returns
to scale), but the curve will exhibit diminishing marginal returns.

6. Assuming Capital is
constant
Y= F(N)
National Y increases
with increase in N
But at a diminishing
rate
Demand Theory states
that Entrepreneurs
employ till
MPL*P=W
W/P= MPL

7. In capitalist economies, firms will only employ the labour (and
other inputs) that they need to. This makes the demand for
labour, the Marginal Productivity of Labour (MPL), a derived
demand.
This function can be worked out from the slope of the short run
aggregate production function. Mathematically speaking, MPL is
the first derivative, δf/δN, of Y=f(N,K¯),
where w is nominal wages, p is the price level and w/p is real
wages. This is shifted by the same factors as Y=f(N,K¯), such
as improvements in technology or increase in capital.

8. In the short run, we can consider K to be fixed ( ). The short
run aggregate production function is then Y=f(N, ),
Varying N will cause a move along the curve, whilst varying K
(or any other input) will shift the curve up or down.
Y=f(N, )
w
p
MPL
In capitalist economies, firms will only employ the labour (and
other inputs) that they need to. This makes the demand for
labour, the Marginal Productivity of Labour (MPL), a
derived demand.
This function can be worked out from the slope of the short
run aggregate production function. Mathematically speaking,
MPL is the first derivative, δf/δN, of Y=f(N,K¯),
where w is nominal wages, p is the price level and w/p is
real wages. This is shifted by the same factors as Y=f(N,K¯),
such as improvements in technology or increase in capital.

9. The Nominal Wage and the Real
Wage
The nominal wage is the wage measured in terms of
current dollars
The real wage is the wage measured in terms of dollars
of constant purchasing power
 The real wage is the wage measured in terms of the quantity of
goods it will purchase
Both workers and employers care more about the real
wage than the nominal wage

10. Wages and Price Level
Expectations
 Nominal wages are
important because
resource agreements (such
as wage contracts) are
typically negotiated in
nominal wages
 Since wage contracts are
negotiated ahead of time,
they are based on workers’
expectation for the price
level

11. 

Y=f(N,K )
Y
w0
p0
w1
p1

N0
N
MPL
N1
N
N0
N1

12. Labor Supply
 The supply of labor depends
primarily on the wage rate
(the dollar cost of a unit of
labor, such as an hour of
work)
 The supply of labor also
depends on
 The size of the adult
population
 The skills (productivity) of
the adult population
 Households’ preferences for
work versus leisure
w0
p0
w1
p1
N0
N1

13. The labour market is in
equilibrium where the two lines
intersect. To the left, the demand
for labour exceeds the supply.
Wages will eventually rise to
restore equilibrium. To the right,
the supply exceeds demand and
there is unemployment.
W/P
W
/P
N
Output
(Y)
Price
N
Y
AS
Factors that may shift the
supply of labour include
income tax, motivation to
work, unemployment
benefit and the value of
leisure time.

14. Potential Output and the Natural Rate of
Unemployment
Potential output is the economy’s maximum
sustainable output level, given the supply of
resources, technology, and the underlying
economic institutions.
Another point of view is the that potential output is
the level of output where there are no “surprises”
about the price level.
The natural rate of unemployment is the rate that
occurs when the economy is producing it potential
level of output

15. Aggregate Supply in the Short Run
Macroeconomists focus on whether or not the
economy as a whole is operating at full
capacity.
As the economy approaches maximum
capacity, firms respond to further increases in
demand only by raising prices.
Hence The Classical Aggregate supply curve is
a vertical line
In long run when all resources are completely
employed then firms respond to increase in
demand by raising prices

16. The Aggregate Supply Curve:
A Warning
When we draw a firm’s supply curve, we
assume that input prices are constant. In
macroeconomics, an increase in the
overall price level means that at least
some input prices will be rising as well.
The outputs of some firms are the inputs
of other firms.

17. The Aggregate Supply Curve:
A Warning
Rather than an aggregate supply curve, what
does exist is a “price/output response” curve —
a curve that traces out the price and output
decisions of all the markets and firms in the
economy under a given set of circumstances.

18. Keynesian Aggregate supply Model
Keynes assumed that input prices in short run are
not flexible ,
At less than full employment level increase in AD
leads to rise in output without increase in wages or
input prices
AS
P
Y

19. The Short Run
The short run is a
period during which
some resources prices,
especially labor, are
fixed by agreement

20. The Short-Run Supply Curve
 If the price level is higher
than expected, the quantity
supplied is above the
economy’s potential output
Price Level
SRAS
 If the price level is lower
than expected, the quantity
supplied decreases
 As a result, there is a positive
short-run relationship
between the price level and
aggregate output supplied
Real GDP

21. Aggregate Supply in the Short Run
At low levels of aggregate
output, the curve is fairly
flat. As the economy
approaches capacity, the
curve becomes nearly
vertical. At capacity, the
curve is vertical.

22. The Sticky Wage Model
W/P
 Many economists believe that nominal
wages are sticky in the short run.
P
When the nominal
wage lower real wage
The is stuck, a rise in
P from P0 to P1to hire
induces firms lowers
The more labour.
additional labour
the real wage, making
hired produces more
labourpositive
The cheaper.
output.
relationship between P
and Y means AS slopes
upward.
W/P
0
W/P
DL
1
L0
L1
Y
Y1
P1
Y = Y + α (P − Pe )
P0
Y0
Y1
Y
L
Y=F(L)
Y0
L0
L1
L

23. Output Levels and
Price/Output Responses
When the economy is operating at low levels of
output, an increase in aggregate demand is likely to
result in an increase in output with no increase in the
overall price level. (Keynesian AS Curve )

24. The Response of Input Prices to
Changes in the Overall Price Level
There must be a lag between
changes in input prices and
changes in output prices,
otherwise the aggregate supply
(price/output response) curve
would be vertical.

25. The Long-Run
Aggregate Supply Curve
Costs lag behind price-
level changes in the short
run, resulting in an
upward-sloping AS curve.
• Costs and the price level
move in tandem in the long
run, and the AS curve is
vertical.

26. Shifts of the Short-Run
Aggregate Supply Curve
A cost shock, or supply shock, is a change in
costs that shifts the aggregate supply (AS) curve.

27. Factors That Shift the Aggregate Supply Curve
Shifts to the Right
Increases in Aggregate Supply
Shifts to the Left
Decreases in Aggregate Supply
Lower costs
lower input prices
lower wage rates
Higher costs
higher input prices
higher wage rates
Economic growth
more capital
more labor
technological change
Stagnation
capital deterioration
Public policy
supply-side policies
tax cuts
deregulation
Public policy
waste and inefficiency
over-regulation
Good weather
Bad weather, natural
disasters, destruction
from wars

28. The Long-Run
Aggregate Supply Curve
Output can be pushed
above potential GDP by
higher aggregate demand.
The aggregate price level
also rises.

29. The Long-Run
Aggregate Supply Curve
When output is pushed
above potential, there is
upward pressure on costs,
and this causes the shortrun AS curve to the left.
• Costs ultimately increase
by the same percentage as
the price level, and the
quantity supplied ends up
back at Y0.

30. The Long-Run
Aggregate Supply Curve
Y0 represents the level of
output that can be
sustained in the long run
without inflation. It is also
called potential output or
potential GDP.

31. Supply, and Monetary and Fiscal
Policy
• AD can shift to the right for
a number of reasons,
including an increase in the
money supply, a tax cut, or
an increase in government
spending.
 Expansionary policy works well
when the economy is on the flat
portion of the AS curve, causing
little change in P relative to the
output increase.

32. Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal
Policy
• On the steep portion of the
AS curve, expansionary
policy does not work well.
The multiplier is close to
zero.
When the economy is
operating near full capacity,
an increase in AD will result
in an increase in the price
level with little increase in
output.

33. Long-Run Aggregate
Supply and Policy Effects
If the AS curve is vertical in
the long run, neither
monetary policy nor fiscal
policy has any effect on
aggregate output.
• In the long run, the
multiplier effect of a change
in government spending or
taxes on aggregate output
is zero.

34. The Simple “Keynesian”
Aggregate Supply Curve
The output of the economy
cannot exceed the maximum
output of YF.
The difference between
planned aggregate
expenditure and aggregate
output at full capacity is
sometimes referred to as an
inflationary gap.

35. Causes of Inflation
Inflation is an increase in the
overall price level.
Sustained inflation occurs when
the overall price level continues to
rise over some fairly long period of
time.

36. Causes of Inflation
• Cost-push, or supply-side,
inflation is inflation caused by
inflation initiated by an
an increase in costs.
increase in aggregate demand.
Demand-pull inflation is

37. Cost-Push, or Supply-Side Inflation
• Stagflation occurs
when output is falling at
the same time that
prices are rising.
• One possible cause of
stagflation is an
increase in costs.

38. Cost-Push, or Supply-Side Inflation
Cost shocks are bad news
for policy makers. The
only way to counter the
output loss is by having
the price level increase
even more than it would
without the policy action.

39. Expectations and Inflation
If every firm expects every other firm to raise
prices by 10%, every firm will raise prices by
about 10%. This is how expectations can get
“built into the system.”
• In terms of the AD/AS diagram, an
increase in inflationary expectations
shifts the AS curve to the left.

40. Money and Inflation
Hyperinflation is a
period of very rapid
increases in the price
level.

41. Money and Inflation
• An increase in G with
the money supply
constant shifts the AD
curve from AD0 to AD1.
This leads to an
increase in the interest
rate and crowding out
of planned investment.

42. Money and Inflation
• If the Fed tries to prevent
crowding, it will increase
the money supply and
the AD curve will shift
farther and farther to the
right. The result is a
sustained inflation,
perhaps hyperinflation.