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Principles of Macroeconomics
Table of Contents
Unit 11 Overview: Aggregate Demand and Supply Model
11.1 Macroeconomic Perspectives on Demand and Supply
11.2 Building a Model of Aggregate Demand and Aggregate Supply
11.3 Shifts in Aggregate Supply
11.4 Shifts in Aggregate Demand
11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
11.6 Keynes’ Law and Say’s Law in the AD/AS Model

Aggregate supply, a key concept in macroeconomics, is influenced by various factors that shape economic output. Productivity growth, input prices, and supply shocks all play crucial roles in determining the economy's production capacity and price levels.

Understanding these factors is essential for grasping how the economy responds to changes in production costs, technological advancements, and unexpected events. These elements impact GDP, inflation, and employment, forming the foundation for analyzing economic fluctuations and policy responses.

Factors Affecting Aggregate Supply

Productivity growth and aggregate supply

  • Productivity growth shifts the aggregate supply curve to the right
    • Increased productivity enables more output produced with same inputs (labor, capital, resources)
    • Higher productivity reduces per-unit production costs (economies of scale)
  • Productivity growth increases potential GDP
    • Potential GDP represents maximum sustainable economic output
    • Productivity improvements expand the production possibilities frontier (PPF) enabling higher output
  • Sources of productivity growth include:
    • Technological advancements (automation, AI)
    • Investments in physical capital (machinery, infrastructure) and human capital (education, training)
    • Improved resource allocation (specialization) and efficiency (lean manufacturing)
    • Enhanced resource availability leading to increased production capacity

Input prices and economic impacts

  • Changes in input prices shift the aggregate supply curve
    • An increase in input prices shifts the aggregate supply curve to the left
      • Examples: rising oil prices (transportation costs), higher wages (labor costs), increased raw material costs (manufacturing inputs)
      • Higher input prices increase production costs and reduce aggregate supply, potentially leading to cost-push inflation
    • A decrease in input prices shifts the aggregate supply curve to the right
      • Examples: falling commodity prices (metals, agricultural products), lower labor costs (outsourcing)
      • Lower input prices decrease production costs and increase aggregate supply
  • The impact on the economy depends on the magnitude and duration of the input price change
    • Short-term fluctuations cause temporary shifts in aggregate supply (seasonal price changes)
    • Persistent changes in input prices have long-lasting effects on economic growth and inflation (structural changes)

Supply shocks in macroeconomics

  • Supply shocks are unexpected events that significantly affect aggregate supply
    • Positive supply shocks shift the aggregate supply curve to the right
      • Examples: major technological breakthroughs (internet revolution), discovery of new resources (oil reserves)
      • Positive shocks increase output and lower prices
    • Negative supply shocks shift the aggregate supply curve to the left
      • Examples: natural disasters (hurricanes, earthquakes), geopolitical events (wars, trade disputes), pandemics (COVID-19)
      • Negative shocks decrease output and raise prices
  • Supply shocks can impact key macroeconomic variables
    • Output and economic growth
      1. Positive shocks boost GDP growth (increased production)
      2. Negative shocks hinder GDP growth (reduced production)
    • Inflation
      1. Positive shocks put downward pressure on prices (increased supply relative to demand)
      2. Negative shocks drive prices up (reduced supply relative to demand)
    • Unemployment
      1. Positive shocks can reduce unemployment (increased labor demand)
      2. Negative shocks may increase unemployment (decreased labor demand)
  • Policymakers may respond to supply shocks with monetary policy (interest rates) or fiscal policy (government spending, taxes) to stabilize the economy

Long-run and Short-run Aggregate Supply

  • Long-run aggregate supply (LRAS) represents the economy's full-employment output level
    • LRAS is vertical, indicating that price level changes do not affect long-term production capacity
    • Shifts in LRAS occur due to changes in factors like technology, capital stock, or labor force
  • Short-run aggregate supply (SRAS) shows the relationship between price level and output in the short term
    • SRAS is upward-sloping, reflecting that higher prices can temporarily increase output
    • SRAS can shift due to changes in input costs, expectations, or supply shocks
  • The interaction between LRAS and SRAS can lead to economic phenomena such as stagflation, where high inflation coexists with slow economic growth and high unemployment

Key Terms to Review (21)

Monetary Policy: Monetary policy refers to the actions taken by a central bank, such as the Federal Reserve in the United States, to influence the money supply and interest rates in an economy. It is a macroeconomic tool used to promote economic growth, stability, and full employment, as well as to manage inflation.
Inflation: Inflation is the sustained increase in the general price level of goods and services in an economy over time. It is a crucial macroeconomic concept that affects the purchasing power of a currency, the cost of living, and the overall economic performance of a country.
Aggregate Supply: Aggregate supply refers to the total quantity of goods and services that firms are willing to sell at different price levels in an economy during a specific time period. It represents the supply-side of the macroeconomic model and is a crucial component in understanding economic growth, inflation, and the business cycle.
Fiscal Policy: Fiscal policy refers to the use of government spending, taxation, and borrowing to influence the overall level of economic activity. It is a macroeconomic tool employed by policymakers to manage the economy and achieve desired outcomes, such as promoting economic growth, reducing unemployment, and controlling inflation.
Unemployment: Unemployment refers to the state of being without a job or not being able to find suitable work. It is an important macroeconomic indicator that measures the portion of the labor force that is jobless and actively seeking employment. Unemployment has significant implications for individuals, the economy, and government policy.
Input Prices: Input prices refer to the costs of the various resources, materials, and factors of production that are used to create goods and services. These input prices are a critical determinant of the supply and overall production in an economy.
Production Possibilities Frontier: The production possibilities frontier (PPF) is a curve that represents the maximum combination of two different goods or services that an economy can produce given its available resources and technology. It illustrates the trade-offs an economy faces in allocating its resources between the production of different goods and services.
Human Capital: Human capital refers to the knowledge, skills, and abilities that individuals possess, which contribute to their productivity and economic value. It is a crucial component of economic growth and development, as it represents the collective expertise, experience, and capabilities of a population that can be leveraged for productive purposes.
Potential GDP: Potential GDP, also known as the full-employment level of GDP, represents the maximum sustainable level of output that an economy can produce when all available resources, including labor and capital, are fully utilized at their most efficient levels. It is the level of real GDP that an economy would achieve if it was operating at full employment without any inflationary pressures.
Physical Capital: Physical capital refers to the tangible, man-made assets that are used in the production of goods and services. It includes machinery, equipment, buildings, and infrastructure that facilitate economic activity and contribute to a country's productive capacity.
Productivity Growth: Productivity growth refers to the increase in the amount of output produced per unit of input, such as labor or capital, over time. It is a crucial factor in driving economic growth and improvements in living standards.
Cost-Push Inflation: Cost-push inflation is a type of inflation where the general price level rises due to increases in the production costs of goods and services. This is in contrast to demand-pull inflation, where prices rise due to increased consumer demand. Cost-push inflation is a significant factor in understanding how the U.S. and other countries experience inflation, as well as its impact on aggregate supply, the Phillips Curve, and inflation in various regions.
Stagflation: Stagflation is a rare economic phenomenon characterized by the simultaneous occurrence of stagnant economic growth, high unemployment, and high inflation. It represents a situation where the economy experiences sluggish economic activity and rising prices, contradicting the typical inverse relationship between inflation and unemployment as described by the Phillips curve.
Long-Run Aggregate Supply: Long-run aggregate supply (LRAS) refers to the relationship between the price level and the economy's total output when all input prices and production technologies have fully adjusted. It represents the maximum level of real GDP that can be produced when all resources are fully employed and all input prices have had time to adjust to the prevailing economic conditions.
Negative Supply Shocks: Negative supply shocks are unexpected events or disruptions that lead to a decrease in the overall supply of goods and services in an economy. These shocks result in a leftward shift of the aggregate supply curve, causing a rise in the general price level and a decline in real output.
Resource Availability: Resource availability refers to the quantity and quality of resources, both natural and human-made, that are accessible and can be utilized to support economic activities and meet the needs of a society. It is a crucial factor that influences the production capacity and potential growth of an economy.
Supply Shocks: Supply shocks are sudden and unexpected changes in the supply of a good or service that lead to significant shifts in the aggregate supply curve. These shocks can have significant impacts on the overall economy, affecting prices, output, and employment levels.
Technological Advancements: Technological advancements refer to the continuous improvements, innovations, and developments in various fields of technology that enhance human capabilities, increase efficiency, and drive economic and social progress. These advancements play a crucial role in shaping the aggregate supply of an economy.
Positive Supply Shocks: Positive supply shocks refer to unexpected events or changes that lead to an increase in the overall productive capacity of an economy, resulting in a rightward shift of the aggregate supply curve. These shocks have the effect of increasing the real output that can be produced at any given price level, thereby lowering inflationary pressures and potentially stimulating economic growth.
Short-Run Aggregate Supply: Short-run aggregate supply (SRAS) refers to the relationship between the quantity of real output supplied and the general price level in the economy, in the short-term time frame. It represents the willingness and ability of producers to sell their products at different price levels, considering the constraints and conditions they face in the short run.
Macroeconomic Variables: Macroeconomic variables are the key economic measures and indicators that economists and policymakers use to analyze and understand the overall performance and health of a national or global economy. These variables provide insights into factors such as economic growth, inflation, unemployment, and trade that influence the well-being of a country and its citizens.