Foundations of aggregate

supply
 Recall:
Aggregate supply
-Describes the behavior of the
production side of the economy
-Total quantity of goods and services
that businesses willingly produced and
sell in a given period.

Aggregate supply Curve/ AS Curve

-schedule showing the level of total
national output that will be produced at
each price level
 Recall:
Short-run AS schedule
-not more than a decade
-upward sloping
-higher prices are associated with
increase in the production of goods and
services

Long-run AS Schedule
-period of several years or a decade more
-vertical AS schedule
-increase in the price level are not
associated with an increase in total output
supplied
 Determinants of Aggregate
supply
Potential Output (Potential GDP)
-maximum sustainable output that can be
produce without triggering rising inflation
-highest sustainable level of national output
-the output that would be produced at a
target level of the unemployment rate
called nonaccelerating inflation rate of
unemployment.

Input(land, labor, capital)

Technology and Efficiency
 Determinants of Aggregate
supply
Potential Output IS NOT Maximum
Output

Maximum sustainable output

but not the absolute
maximum output that an Analogy: Someone Running a
economy can produce Marathon

Think of potential output as

the maximum speed that a
marathoner can run without
being overheated and dropping
out of exhaustion.
 a. Increase in potential
output
Potential output

AS AS
Price level

Q
QP QP
Real output
 Determinants of Aggregate
supply
Input Costs
Wages
-lower wages lead to lower production costs
-lower costs means that quantity supplied will be
higher at every price level for a given potential
output

Import Prices
-decline in foreign prices or an appreciation in
the exchange rate reduces import prices. This
leads to lower production costs and raises
aggregate supply.
Determinants of Aggregate
supply
Other Input Costs
Lower oil prices or less burdensome
environmental regulations lowers production
costs and thereby raises aggregate supply
 b. Increase in costs
Potential AS
output
AS
Price level

Q
Real Output
QP
 Aggregate supply and potential
P
output
2
AS
Price level (1996=100)

curve
for
2000

AS
curve
for
1982
Q
2,ooo 4,ooo 6,ooo 8,ooo

Real GDP(billions, 1996 prices)

Aggregate Supply in the
Short Run and Long Run
 Views in looking at Aggregate
Supply
Keynesian upward-sloping;
indicates that firms are willing to
increase their output levels in
response to changes in aggregate
demand, particularly when there is a
slack in the economy.
Classical Approach the level of
output supplied is independent of
aggregate demand.
 During Short-runs
Some elements of business are
inflexible or sticky.
As a result of this inflexibility,
business can profit from higher levels
of aggregate demand by producing
more output.
 Price Level
P

Potential
Output

Real Output
Qp
AS

Q
 Example!
Wages
Wages adjust slowly when economic
conditions change for a number of
reasons.
Workers are less likely to get an increase
in their wages more than once a year.
So firms can adjust the production to
suit the aggregate demand.
However, during long-runs
Eventually, the inflexible or sticky
elements of costswage contracts, rent
agreements, regulated prices, and so forth
become unstuck and negotiable.
In the long-run, after all elements of cost
have fully adjusted, firms will face the
same ratio of price to costs as they did
before the change in demand.
The long-run AS curve therefore tends to
be vertical, which means that output
supplied is independent of the levels of
prices and costs
 Price Level
P

Potential
Output

Real Output
Qp
Q
UNEMPLOYMENT
 TERMS
Employed
People who perform paid work
Unemployed
People who currently have no work
but are willing and able to work
Labor Force
All people who are employed and
unemployed
 TERMS
Unemployment rate
The number of unemployed divided
by the total labor force
IMPACT OF UNEMPLOYMENT
Economic Impact

When unemployment goes up, the G&S

that the unemployed workers could
have produced are in effect as if being
thrown away.

Social Impact
 OKUNS LAW
The most distressing consequence of recession is
the rise of a unemployment rate.
Okuns Law states the for every 2 percent that
GDP falls relative to the potential GDP, the
unemployment rate rises about 1 percentage
point.
Unemployment usually moves inversely with
output over the business cycle.
This co-movement was first identified by Arthur
Okun.
 According to Okuns Law, whenever output grows 2 percent
faster than potential GDP, the unemployment rate declines 1
percentage point.
Unemployment changes are well predicted by the rate of GDP
growth.
One important consequence of Okuns Law is that actual GDP
must grow rapidly as potential GDP just to keep the
unemployment rate from rising.
In sense, GDP has to keep running just to keep unemployment
in the same place. Moreover, if you want to bring the
unemployment rate down, actual GDP must be growing faster
then potential GDP.
Okuns Law provides the vital link between the output market
and the labor market. It describes the association between
short-run movements in real GDP and changes in
unemployment.
Economic Interpretation of
Unemployment
Maguad, John Albert T.
2009-21425
 What are the reasons for being
unemployed?

What is the distinction between

voluntary and involuntary
unemployment?
Three Kinds of
Unemployment
Frictional Unemployment

Structural Unemployment

Cyclical Unemployment
 Frictional Unemployment

Arises because of the incessant

movement of people between
regions and jobs or through different
stages of the life cycle.

Frictionally unemployed workers are

often moving between jobs or looking
for better jobs.
 Structural Unemployment

Signifies a mismatch between the

supply of and the demand for workers.

We often see structural imbalances

across occupations or regions as
certain sectors grow while others
decline.
 Cyclical Unemployment

Exists when the overall demand for

labor is low.

As total spending and output fall,

unemployment rises virtually
everywhere.
Voluntary and Involuntary
Unemployment
Sources of Wage Inflexibility
Why do wages not move up or down
to clear markets?

Auction Markets
Administered Markets
Labor Market Issues
Duration of unemployment
Sources of joblessness
1982 2000
Job loser 5.7 1.8
Reentran 2.2 1.3
t
New 1.1 0.3
entrant
Job 0.8 0.5
leaver
Unemployment by age
Age White Black
16-17 15.2 31.1
18-19 11.1 27.6
20-24 6.9 16.2
25-34 4.1 8.1
35-44 3.2 6.4
45-54 2.8 4.8
55-64 2.9 3.9
65-69 2.9 4.8
70-74 2.8 3.1
Over 75 2.8 3.3
Philippines
Youth unemployment

2009 17.4
2008 17.5
2007 14.9
2006 16.9
2005 16.4
2004 21.7
2003 20.1
2002 21.4
2001 19.0
2000 21.2