1) The document discusses aggregate supply, which is the relationship between the price level and the amount of output firms are willing to supply given resource prices, technology, and institutions. 2) It explains how shifts in aggregate supply can lead to expansionary or contractionary gaps in the short run that are closed through price level adjustments in the long run. 3) Beneficial supply shocks increase aggregate supply, lowering prices and raising output, while adverse shocks decrease supply, raising prices and lowering output.

1. CChhaapptteerr 1100
AAggggrreeggaattee SSuuppppllyy

2. Aggregate SSuuppppllyy iinn tthhee SShhoorrtt--RRuunn
• Aggregate supply is the relationship between
the economy’s price level and the amount of
output firms are willing and able to supply.
• Along the supply curve, resource prices, the
state of technology, and the set of formal and
informal institutions are held constant.

3. LLaabboorr aanndd AAggggrreeggaattee SSuuppppllyy
• The most important resource in production
– 70% of production cost
– The quantity of labor supplied depends on the
wage
• The higher the wage, the more labor supplied, OTHC

4. LLaabboorr aanndd AAggggrreeggaattee SSuuppppllyy
• The higher the price level, the less purchasing
power, so the less attractive that wage is to
workers.
• Nominal wage or money wage: the wage
measured in dollars of the year in question; the
dollar amount on your paycheck.
• Real wage: the wage measured in dollars of
constant purchasing power; the wage measured in
terms of the quantity of goods and services it buys.

5. http://www.usinflationcalculator.com/inflation/
current-inflation-rates/

7. PPootteennttiiaall OOuuttppuutt aanndd tthhee NNaattuurraall RRaattee
ooff UUnneemmppllooyymmeenntt
• Firms and resource suppliers reach an
agreement based off a consensus view of the
coming year.
• If the actual price= expected price level, then
the economy is at potential output.
– The maximum sustainable output, given current
resources, technology, and rules of the game.

8. PPootteennttiiaall OOuuttppuutt aanndd tthhee NNaattuurraall RRaattee
ooff UUnneemmppllooyymmeenntt
• Potential Output= Natural Rate of Output= the
Full-Employment rate of output
• When the economy is at potential output,
then the natural rate of unemployment is
met.
– Cyclical unemployment = zero
– The range is between 4 to 6 percent

9. AAccttuuaall PPrriiccee LLeevveell iiss HHiigghheerr TThhaann
EExxppeecctteedd
• What happens in the short-run if price level is
higher than expected?
– This is time period during which some resource prices
remain FIXED BY CONTRACTS.
– In the short-run, firms have an incentive to increase
production beyond the economy’s potential level.
– Increased per-unit production cost, meaning marginal
cost increases
– Why?
• Higher prices= Higher profits

10. AAccttuuaall PPrriiccee LLeevveell iiss LLoowweerr TThhaann
EExxppeecctteedd
• In the short-run, firms have an incentive to
decrease production beyond the economy’s
potential level.
– Decreased per-unit production cost, meaning
marginal cost decreases
– Why?
• Lower prices=Lower profits

11. TThhee SShhoorrtt--RRuunn AAggggrreeggaattee SSuuppppllyy CCuurrvvee
((SSRRAASS))
• The SRAS shows the relationship between the
actual price level and real GDP supplied,
OTHC.
– The short-run is described as a period of time
during which some resource prices are fixed by
agreements, in particular, LABOR!!

12. LO1
Short-Run Aggregate Supply Curve
SRAS130
Potential
output
Price
level
140
130
120
Real GDP
a
(trillions of dollars)
0 14.0
The SRAS curve is based on a
given expected price level, in this
case, 130. Point a shows that if the
actual price level equals the
expected price level of 130,
producers supply potential output.
If the actual price level is below
130, firms supply less than
potential. Output levels that fall
short of the economy’s potential
are shaded red; output levels that
exceed the economy’s potential
are shaded blue.
Exhibit 1

13. CClloossiinngg aann EExxppaannssiioonnaarryy GGaapp
• The long-run is long enough that firms and
resource suppliers can renegotiate all
agreements based on knowledge of the actual
price level.
– In the long-run, no surprises about price level.

14. CClloossiinngg aann EExxppaannssiioonnaarryy GGaapp
• What if aggregate demand turns out to be
greater than expected?
– In the short-run:
• Actual price level is greater than expected
• Output exceeds the economy’s potential output
– Real GDP exceeds potential
– The unemployment rate is less than its natural rate
– The amount by which it exceeds potential output is the
expansionary gap.

15. Long-Run Adjustment When the Price
Level Exceeds Expectations
Expected price level=130, SRAS130
If actual price level turns out as
expected, the quantity supplied =
potential output of $14 trillion.
Given the AD curve, price level >
expected; output exceeds potential
(b); expansionary gap.
In the long-run, price-level
expectations and nominal wages
will be revised upward. Costs will
rise and the SRAS curve shifts
leftward to SRAS140. Eventually, the
economy will move to long-run
equilibrium (c), thus closing the
expansionary gap.
LO2 Exhibit 2
Potential output
Price
level
140
135
130
SRAS140
SRAS130
AD
b
Real GDP
c
0 14.0 14.2
(trillions of dollars)
a
LRAS

16. CClloossiinngg aann EExxppaannssiioonnaarryy GGaapp
• In the long-run:
– Workers will demand a higher nominal wage
– Increased production costs
• Shifting the SRAS leftward
– Lower output

17. CClloossiinngg aann EExxppaannssiioonnaarryy GGaapp
• Long-run equilibrium:
– Expected price level=actual price level
– Quantity supplied in short-run = quantity supplied
in long-run
– Quantity supplied= quantity demanded

18. CClloossiinngg aann CCoonnttrraaccttiioonnaarryy GGaapp
• What if aggregate demand turns out to be less
than expected?
– In the short-run:
• Actual price level is less than expected
• Output less the economy’s potential output
– Real GDP less than potential
– The unemployment rate is higher than its natural rate
– The amount by which actual output falls short of potential
output is the contractionary gap.

19. Long-Run Adjustment When the Price
Level Is Below Expectations
Actual price level < expected
(intersection of AD” with SRAS130);
short-run equilibrium: (d). Production
below economy’s potential opens a
contractionary gap.
If prices and wages are flexible
enough in the long run, nominal
wages will be renegotiate lower. As
resource costs fall, the short-run
aggregate supply curve eventually
shifts rightward to SRAS120 and the
economy moves to long-run
equilibrium at (e), with output
increasing to the potential level of
$14.0 trillion.
LO2 Exhibit 3
Potential output
Price
level
130
125
120
SRAS130
AD”
d
Real GDP
(trillions of dollars)
0 13.8 14.0
SRAS120
e
LRAS
a

20. CClloossiinngg aann CCoonnttrraaccttiioonnaarryy GGaapp
• Long run
– Lower nominal wages
– Lower cost of production
– SRAS shifts right
– Deflation
– Greater output
– Long-run equilibrium

21. TTrraacciinngg PPootteennttiiaall OOuuttppuutt
• The long-run aggregate supply (LRAS) depends on
the supply of resources in the economy, the level of
technology, and the production incentives provided
by the formal and informal institutions of the
economic system.
• Depends on:
– Supply of resources in the economy, level of technology,
and production incentives
– Long-run equilibrium:
– Output = LRAS = potential output
– Price level depends on AD curve

22. Long-Run Aggregate Supply Curve
In the long run, when the actual
price level equals the expected
price level, the economy produces
its potential. In the long-run, $14.0
trillion in real GDP will be supplied
regardless of the actual price
level. As long as wages and
prices are flexible, the economy’s
potential GDP is consistent with
any price level. Thus, shifts of the
aggregate demand curve will, in
the long-run, not affect potential
output. The long-run aggregate
supply curve, LRAS, is a vertical
line at potential GDP.
LO2 Exhibit 4
Price
level
140
130
120
Potential output
LRAS
AD”
AD’
Real GDP
(trillions of dollars)
0 14.0
AD
b
a
c

23. WWaaggee FFlleexxiibbiilliittyy aanndd EEmmppllooyymmeenntt
 Expansionary gap
– Labor shortage
– Higher nominal wage
– Higher price level
 Contractionary gap
– Nominal wages = “sticky” downward
– Slow to close

24. SShhiiffttss ooff AAggggrreeggaattee SSuuppppllyy CCuurrvvee
• Aggregate supply increases, LRAS
– Increased quantity and quality of labor and other
resources
– Institutional changes
– Does so gradually

25. Effect of a Gradual Increase in
Resources on Aggregate Supply
A gradual increase in the
supply of resources
increases the potential
GDP – in this case, from
$14.0 trillion to $14.5
trillion.
The long-run aggregate
supply curve shifts to the
right.
LO3
Exhibit 5
Price level
LRAS LRAS’
Real GDP
0 14.0 14.5
(trillions of dollars)

26. Shifts of the Aggregate
Supply Curve
 Supply shocks
 Unexpected events
 Beneficial supply shocks
 Increase aggregate supply (SRAS,
(SRAS, LRAS)
 Abundant harvests
 Discoveries of natural resources
 Technological breakthroughs
 Sudden changes in economic system;
tax cuts
 Higher output; lower price level

27. Effects of a Beneficial
Supply Shock on
Aggregate Supply
Given the AD curve, a beneficial
supply shock that has a lasting
effect, such as a breakthrough in
technology, will permanently shift
both the short-run aggregate supply
curve and the long-run aggregate
supply curve, or potential output. A
beneficial supply shock lowers the
price level and increases output, as
reflected by the change in
equilibrium from a to b.
Exhibit 6
LRAS LRAS’
SRAS125
AD”
SRAS130
Real GDP
Price
level
130
125
a
0 14.0 14.2
b
(trillions of dollars)
A temporary beneficial supply shock (an unusually favorable growing season), will shift
the AS curves only temporarily. If the next growing season returns to normal, the AS
curves will return to their original equilibrium position at a.

29. SShhiiffttss ooff tthhee AAggggrreeggaattee
SSuuppppllyy CCuurrvvee
 Adverse supply shocks
 Decrease aggregate supply
(SRAS, LRAS)
 A drought
 Overthrow of government
 Terrorist attacks
 Stagflation
 Lower output
 Higher price level

30. Effects of an Adverse
Supply Shock on
Aggregate Supply
Given the AD curve, an adverse
supply shock, such as an
increased threat of terrorism, shifts
the short-run and long-run
aggregate supply curves to the
left, increasing the price level and
reducing real GDP, a movement
called stagflation. This change is
shown by the move in equilibrium
from a to c.
LO3 Exhibit 7
LRAS” LRAS
SRAS135
SRAS130
AD”
Real GDP
Price
level
130
125
c
0 13.8 14.0
a
(trillions of dollars)
If the shock is just temporary, the shift of the aggregate supply curves will be
temporary.