Aggregate Demand

1
Aggregate Demand SupplyPart II Supply

2
Aggregate Supply

• Aggregate Supply total goods services
  supplied
• Aggregate Supply Curve
• relates total goods services supplied to
  general price level, Y f(P)
• ? disagreement over derivation
• ??disagreement over shape
• Theorists distinguish between short run and long
  run aggregate supply curves

3
Aggregate S ? ?si

• Just as the aggregate demand curve is not equal
  to the sum of individual demand curves, so too
  with supply
• Individual supply curves are based on ceteris
  paribus assumption
• But with general rise in price level, all prices
  rise, including input prices so ceteris paribus
  can't hold

4
Aggregate Supply Results

• So, aggregate supply is not really derived, it is
  presented as what happens on the whole, the net
  result of all firms responses to average changes
  in the price level
• Yet, reasoning about the shape of the aggregate
  supply curve is carried on in terms of the way
  firms might be expected to act in various
  situations --based on microeconomic theory about
  firm decision making

5
Firm Theory

• Microeconomic theory of the firm, says firms
• maximize net revenue or profit
• rising input prices shift cost curves up and
  (ceteris paribus) reduce supply
• falling input prices shift cost curves down and
  (ceteris paribus) increase supply
• Let's look at an example

6
Perfectly Competitive Firm - I

• Output prices are given, max ? w/ MC MR

MC
price
AC
p1
given price MR
Q1
Output
7
Perfectly Competitive Firm - II

• If costs fall, output will rise, with MC' MR

MC
price
MC'
Note
p1
no change in given price!
Q1
Q2
Output
8
Perfectly Competitive Firm - III

• If Output prices rise, output rises

MC
price
AC
p2
p1
PMR
Q1
Q2
Output
9
Contradiction

• Note, reasoning about aggregate supply relates
  general price changes to output decisions
• But
• FALLING input prices result in increased output
• RISING output prices result in increased output

10
Solution?

• Consider response of firms to overall price level
• what this means is by no means clear, not in
  micro theory
• Consider firms' short run capacity
• in micro terms this is shape of cost curve
• Consider lags between increases in overall price
  level and inputs, especially wages(!)
• Clearly, the reasoning is only partially based on
  microeconomic firm theory

11
Positive Slope?

• In general, it is assumed that in the short run
  firms will INCREASE output as the price level
  rises but with increasing difficulty as they
  approach their capacity (i.e., costs increase)
  determined by fixed production assets
• Because we are dealing with aggregates, capacity
  is related, as in Keynesian theory, to "full
  employment" level of Y

12
Aggregate Supply Curve

• So, aggregate supply is assumed to look like this

AS
P
Y
13
Changing slope?

• At low levels of Y, AS is assumed to be
  relatively flat

AS
P
rationale easy to increase output, input prices
lag, esp. wages
? excess capacity
Y
14
Changing slope?

• At higher levels of Y, AS is assumed to be
  relatively vertical

? less excess capacity
AS
P
rationale harder to???output as input prices
?, esp. wages
Y
15
Wage - Price Relation

• A central issue here is the relationship between
  changes in prices and changes in wages
• do wage changes lag price changes?
• do wage changes keep up with price changes?
• e.g., indexed wages?
• if prices wages adjust the same, then profit
  maximization would result in no change in output,
  --AS would be vertical
• because ALL wages are almost never indexed, some
  will fall behind and rising prices will increase
  profits and result in higher output, e.g., upward
  slope

16
Shifts in AS curve

• Anything that changes price - output decisions
  will shift curve

AS
P
Y
17
Cost Shocks

• Changes in basic costs, e.g., wages or oil,
  change costs for most firms

AS
P
? wages ?????costs ????AS
? oil price ????costs ????AS
Y
18
Growth Stagnation

• Changes in available means of production, eg.,
  labor or capital shifts AS

AS
P
? labor ????capacity ????AS
? capital ????capacity ????AS
Y
19
Public Policies

• Policies that increase or decrease costs shift AS

AS
P
? EPA ????costs ????AS
? regulation ????costs ????AS
Y
20
--END--