Shifts in Short run Aggregate Supply

10 Key excerpts on "Shifts in Short run Aggregate Supply"

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  eBook - PDF

  Economics

  A Contemporary Introduction

  • William A. McEachern(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Unexpected changes in the price level can move output in the short run away from its potential level. But if firms and resource suppliers fully adjust to price surprises, the economy in the long run moves toward its potential output. Potential output is the anchor for analyzing aggregate supply in the short run and long run. Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 24 Aggregate Supply 563 Summary 1. Short-run aggregate supply is based on resource demand and supply decisions that reflect the expected price level. If the price level turns out as expected, the economy produces its potential output. If the price level exceeds expectations, short-run output exceeds the economy’s potential, creating an expansionary gap. If the price level is below expectations, short-run output falls short of the economy’s potential, creating a recessionary gap. 2. Output can exceed the economy’s potential in the short run, but not in the long run. In the long run, higher nominal wages will be negotiated at the earliest opportunity. This increases the cost of production, shifting the short-run aggregate supply curve leftward along the aggregate demand curve until the economy produces its potential output. 3. If output in the short run is less than the economy’s potential, and if wages and prices are flexible enough, lower nominal wages will reduce production costs in the long run. These low- er costs shift the short-run aggregate supply curve rightward along the aggregate demand curve until the economy produces its potential output.

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  Macroeconomics

  A Contemporary Introduction

  • William A. McEachern(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Unexpected changes in the price level can move output in the short run away from its potential level. But if firms and resource suppliers fully adjust to price surprises, the economy in the long run moves toward its potential output. Potential output is the anchor for analyzing aggregate supply in the short run and long run. Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 10 Aggregate Supply 231 Summary 1. Short-run aggregate supply is based on resource demand and supply decisions that reflect the expected price level. If the price level turns out as expected, the economy produces its potential output. If the price level exceeds expectations, short-run output exceeds the economy’s potential, creating an expansionary gap. If the price level is below expectations, short-run output falls short of the economy’s potential, creating a recessionary gap. 2. Output can exceed the economy’s potential in the short run, but not in the long run. In the long run, higher nominal wages will be negotiated at the earliest opportunity. This increases the cost of production, shifting the short-run aggregate supply curve leftward along the aggregate demand curve until the economy produces its potential output. 3. If output in the short run is less than the economy’s potential, and if wages and prices are flexible enough, lower nominal wages will reduce production costs in the long run. These low- er costs shift the short-run aggregate supply curve rightward along the aggregate demand curve until the economy produces its potential output.

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  Macroeconomics For Dummies

  • Dan Richards, Manzur Rashid, Peter Antonioni(Authors)
  • 2016(Publication Date)
  • For Dummies

    (Publisher)

  Chapter 10 for details). In the short run, the interaction of aggregate supply and aggregate demand determines how much a country produces (GDP) and how much on average those goods will cost to purchase (the price level), as well as how fast that price level is changing (inflation), plus how much unemployment an economy experiences.

  Looking at long-run aggregate supply

  Economists distinguish between the short run and the long run because the economy behaves in a different way depending on the time frame you’re looking at. The important thing about the long run is that prices are fully flexible (they can change a lot), whereas in the short run prices are sticky (they don’t change by very much — check out the later section “Pulling apart why prices can be sticky ” for some suggested causes of this stickiness).

  Saying that prices are sticky is a way of saying something important about the behavior of suppliers. When demand for any product increases, the businesses that make those goods can do one of three things:

  • Hold output constant and raise their price until the extra demand is choked off
  • Hold the price constant and increase supply enough to meet all the new demand
  • Do a bit of both

  The same options arise for the workers, who supply labor, and the capitalists who supply capital to the firms. In response to a rising demand for their services, they can supply more labor and capital services, raise their compensation demands, or, again, do some of both.

  In the long run, it’s the first option that best describes agents’ behavior in a macro sense. Given enough time, a rise in demand leads to a higher overall aggregate price level P (and higher wages, too) but no more output. In the short run, it’s the second choice that rules. Initially, prices and wages are held in check in response to a demand shock. The result is that, in the short run, a rise in demand evokes mostly an increase in production, whereas a fall in demand induces production to fall. In this section, we review briefly the long-run supply behavior, which is really what the growth model of Chapter 8

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  Macroeconomics for Business

  The Manager's Way of Understanding the Global Economy

  • Lawrence S. Davidson, Andreas Hauskrecht, Jürgen von Hagen(Authors)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  For example, an oil price hike caused by military conflicts in the Middle East would be an oil price shock. In contrast, an oil price hike caused by an increase in firms’ demand for oil following an increase in aggregate demand would not be considered to be a shock. 3.3.1 Short-Run Supply Shocks Consider a sudden increase in crude oil prices as an example of an oil price shock: • Above we argued that this should cause a reduction in aggregate supply – that is, the increase in business costs would lead to lower employment and output at the initial price level. In Figure 3.4, the AS curve shifts to the left as indicated by the blue arrow and the curve labeled AS’. At the initial price level P 0 , aggregate supply is now less than aggregate demand. Find the level of output firms would produce at the initial price level, P 0 . • As firms begin to reduce output, the markets for goods and services are disrupted. • This aggregate shortage leads to pressure for the price level to rise. • A rise in the price level reduces aggregate demand toward the lower level of aggregate supply. At the same time, the rise in the price level makes firms willing to produce more than at the price level P 0 . We move along the AD curve until the 102 Aggregate Supply and Short-Run Equilibrium new intersection with the AS curve is reached. This is indicated by the light- blue arrow. • The result is a new macroeconomic equilibrium indicated by the light-blue dot. It comes with a higher price level, P 1 , and a lower real GDP, Y 1 . Next, consider a reduction in the cost of labor due to a cut in payroll taxes: • The tax cut is tantamount to a reduction in marginal cost and leads to an increase in employment and output. In Figure 3.5, the AS curve shifts to the right as indicated by the blue arrow and the line labeled AS’. • At the initial price level P 0 , aggregate supply becomes larger than aggregate demand. • This excess of supply over demand leads to a decreasing price level.

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  Money, Banking, Financial Markets and Institutions

  • Michael Brandl(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  But you can’t do this forever. If you continue to rev the car engine at very high revolutions per minute, eventually the engine will burn up. (Don’t try this at home.) And so it goes with an economy. An economy can have an actual level of output above its potential for a short period of time, but eventually prices will increase and the economy will “break” as it suffers from growing inflation. When this occurs, the level of output will return to, at most, the potential level of output. SECTION REVIEW Q1) Explain the difference between movement along the short-run aggregate supply curve and shifts of the short-run aggregate supply curve. Q2) Why is the long-run aggregate supply curve vertical? Why might the long-run aggregate supply curve move? Q3) If the cost of doing business for producers increases, which of the following occurs? a. The short-run aggregate supply curve becomes flat. b. The short-run aggregate supply curve shifts outward. c. The short-run aggregate supply curve becomes steep. d. The short-run aggregate supply curve shifts inward. Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 126 CHAPTER 2 Sample Design About Money 6-5 Business Cycles Now that we have the three pieces of the rational expectations framework—AD, SRAS, and LRAS—let’s bring them all together. 6-5a Bringing Together Aggregate Demand, SRAS, and LRAS The actual level of output, or actual GDP, is determined by the intersection of the SRAS (out-put) and AD (spending). This actual level of output can and does change as the SRAS and/or AD changes.

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  Macroeconomics

  Principles and Policy

  • William Baumol, Alan Blinder(Authors)
  • 2015(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  This chapter took the next step by showing how shifts in the aggregate demand curve cause fluctuations in both real GDP and prices—fluctuations that are widely decried as undesirable. It also sug-gested that the economy’s self-correcting mechanism works, but slowly, thereby leaving room for government stabilization policy to improve the workings of the free market. Can the government really accomplish this goal? If so, how? These are some of the important questions for Part 3. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 10 Bringing in the Supply Side: Unemployment and Inflation? 211 1. The economy’s aggregate supply curve relates the quantity of goods and services that will be supplied to the price level. It normally slopes upward to the right because the costs of labor and other inputs remain relatively fixed in the short run, meaning that higher selling prices make input costs relatively cheaper and therefore encourage greater production. 2. The position of the aggregate supply curve can be shifted by changes in money wage rates, prices of other inputs, technology, or quantities or qualities of labor and capital. 3. The equilibrium price level and the equilibrium level of real GDP are jointly determined by the intersec-tion of the economy’s aggregate supply and aggregate demand schedules. 4. Among the reasons why the oversimplified multiplier formula is wrong is the fact that it ignores the inflation that is caused by an increase in aggregate demand. Such inflation decreases the multiplier by reducing both consumer spending and net exports.

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  Patentism Replacing Capitalism

  A Prediction from Logical Economics

  • Samuel Meng(Author)
  • 2019(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  3 .

  So far, we have assumed that the short-run AS is steeper than the long-run AS. The reasoning behind this assumption is that, due to the fixed capital or firm size in the short run, the cost of production in the short run increases faster than that in the long run. The other factor that needs to be taken into account is the input price. When the output level is high, the pressure on limited resources will drive up input prices and increase the long-run production cost sharply. However, firms are unable to perceive resource limits correctly in a timely fashion, so the slope of the short-run AS curve is unlikely to be affected by a future rise in input costs. This will create a situation where the slope of LRAS is greater than that of SRAS when production is approaching resource limits, shown as SRAS4 and SRAS5 in Fig. 4.31 .

  In this case, when a positive demand shock shifts the aggregate demand from AD4 to AD5 , the output level will increase to point G where AD5 intersects with SRAS4 . Here, the output can be greater than the resource limit can support, because we assume a soft resource limit, or a limit with a buffer. There is no economy operating at absolute resource limit, but when it is close to this limit (i.e. within the buffer zone), the extremely high price makes it very hard to go further to reach the absolute limit. The buffer zone can be viewed as a soft resource limit. Once the firm realizes the unexpected degree of the input prices hike and revises its production cost by including the factor of input price increases, the short-run supply curve shifts to SRAS5 and the output level falls back to the level supported by soft resource limits. It is worth mentioning that this explanation is similar to but actually different from the money illusion argument because there is no change in the money supply here.

  1. 2. Business cycles and economic growth  

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  Foundations of Macroeconomics

  Its Theory and Policy

  • Frederick S. Brooman(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  3. Variations in Price and Money Wages

  The intersection of the aggregate supply and demand curves indicates both the equilibrium level of physical output and (given the constant money wage w̄) the equilibrium level of prices. If an autonomous change in “real” demand occurs, it will shift the aggregate demand curve to intersect the aggregate supply curve at a new equilibrium position. Thus, in Figure 10.3 , an increase in real investment will raise the aggregate demand curve from d1 (Q,p) to d2 (Q,p); equilibrium moves from E1 to E2 , output rises from Q1 to Q2 , and prices increase from the level indicated by the slope of p1 to that indicated by the slope of p2 . As long as firms continue to offer their output at its supply price (i.e., w̄) MPL), their response to the increase in demand will be to attempt to produce more commodities and to raise their selling prices only when the expansion of output and employment reduces the marginal product of labor, making price increases necessary to meet the rising value of ‘w̄/MPL. The transition from the old equilibrium at E1 to the new one at E2 will then take the form of an upward movement along the aggregate supply curve.

  However, firms may react in a different way. Faced with excess demand equal to E1 T in money terms, they may begin by raising prices to the level that buyers seem willing to pay – namely, the price level p3 . The price rise will immediately create an incentive for firms to increase production, since the excess of price over marginal labor cost w̄/MPL shows that they will add to their profits if they hire more labor and expand output; but before the expansion can get under way, the situation may be made more complicated by the effects of the price increase on aggregate demand. If the “real” relationship between income and demand remains unchanged, the amount of money that buyers wish to spend will rise in the same proportion as the price level, and in money terms the excess demand will be still larger than before.11 On the other hand, the price increase will have set the redistribution effect to work, because with money wages constant, real wages have fallen; at the original level of output Q1 , both total real wages and the “wage share” in income will be reduced in proportion to the rise in prices, causing a fall in real consumption to the extent that the wage earners’ MPC exceeds the MPC of profit recipients.12

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  A Primer on Macroeconomics

  Policies and Perspectives

  • Thomas M. Beveridge(Author)
  • 2018(Publication Date)
  • Business Expert Press

    (Publisher)

  their jobs, put in a bit more effort. This is a temporary phenomenon—once normality returns, workers ease off once more.

  Expectations about Inflation:

  We have concluded that changes in resource costs affect the position of the SRAS curve. But, one step back, expectations about inflation influence resource costs. If workers expect the inflation rate to be zero, then they ought to be content with their current wage settlement. However, if they believe the inflation rate will rise to 7 percent, then (even though this belief is mistaken!) they will feel justified in asking for a wage hike of 7 percent that will increase per-unit costs, decrease profits, and push the SRAS curve to the left. Similarly, if employers’ expectations regarding future prices change, for example, a new expectation of rising prices, then firms will anticipate higher wage claims and rising costs, and, in response, they will decrease output at any given price level—the SRAS curve will shift to the left. On the other hand, if there is a downward adjustment in expected inflation rates, then the SRAS curve will shift to the right.

  Macroeconomic Equilibrium: Balance in the Short Run Reaching Short-Run Equilibrium

  In this section, we examine how the macroeconomy achieves short-run equilibrium. Considering Figure 5.11 , we have done enough economics by this point to realize that initial equilibrium occurs where the two curves, AD1 and SRAS1 , intersect, at an aggregate price level of P* and an output level of y*. However, it is worthwhile to trace through the process by which the economy achieves that equilibrium.

  To analyze the equilibrating process, let us suppose that the AD curve initially is at AD0 , and that the equilibrium price and output are P0 and y0 , respectively. Now aggregate demand increases from AD0 to AD1

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  Applied Intermediate Macroeconomics

  • Kevin D. Hoover(Author)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  But aggregate supply and aggregate demand are differ-ent things, and ex ante they need not be equal. Aggregate demand is gov-erned by the choices of spenders, given their incomes. Aggregate supply is governed by the choices of firms, given the available productive resources. In the end, it is these productive resources that set the upper limit to GDP. 309 310 Aggregate Production Aggregate demand may fall short, and GDP may turn out to be less than it could be. But no matter how much aggregate demand rises, GDP cannot exceed the ability of the workers in factories, offices, and other worksites to produce. In this and the following three chapters we examine aggregate supply. We know from our discussion of the circular flow of income and produc-tion (Chapter 2, section 2.2) that the firm sector purchases factors of produc-tion and transforms them into final goods and services. This is the heart of aggregate supply. The decisions that govern the production process are not made by the firm sector as a whole. Rather they are made by each individ-ual firm. As a result, even though we are, in the end, concerned primarily with the aggregate product (GDP), looking at the production problem from the point of view of the firm is a valuable prelude to the main business of the chapter. It will help us to build up our intuitions and to cement essential terminology in our minds. 9.1 The Production Decisions of Firms 9.1.1 Production Possibilities Technology Consider a particular product, say, a barrel of gasoline. An oil refinery uses raw petroleum, energy, various chemicals, and various types of labor, among other INPUTS , to produce its OUTPUT – gasoline. The design of the refinery and its work practices embody a particular TECHNIQUE for producing gaso-line. A technique is like a recipe for a cake. The inputs are the list of the ingredients used, the output (or possibly outputs) is the cake, and the recipe is the set of instructions for making the cake.

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