Chapter 9

AGGREGATE SUPPLY
AND MACROECONOMIC
EQUILIBRIUM

Ifeanyi Uzoka, Sheridan College

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Chapter 9 Preview
9.1 The Aggregate Supply Curve
9.2 Shifts in the Aggregate Supply Curve
9.3 Macroeconomic Equilibrium

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 9.1 The Aggregate Supply Curve
 The section will answer the following key questions:
◦ What is the aggregate supply curve?
◦ Why is the short-run aggregate supply curve positively
sloped?
◦ Why is the long-run aggregate supply curve vertical at
the natural rate of output?

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 9.1 The Aggregate Supply Curve
 What is the aggregate supply curve?
◦ Aggregate supply (AS) curve is a graphical
representation that shows the positive relationship
between the price level and RGDP supplied.
◦ There are two aggregate supply curves:
 Short-run aggregate supply curve (SRAS), and
 Long-run aggregate supply curve (LRAS)

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 9.1 The Aggregate Supply Curve
 What is the aggregate supply curve? [cont’d]
◦ Short-run aggregate supply (SRAS) curve is the
graphical relationship between RGDP and the price level
when output prices can change but input prices are
unable to adjust.

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 9.1 The Aggregate Supply Curve
 What is the aggregate supply curve? [cont’d]
◦ Long-run aggregate supply curve (LRAS) is the
graphical relationship between RGDP and the price level
at which output prices and input prices can fully adjust
to economic changes.

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9.1 The Aggregate Supply Curve
Exhibit 1: The Short-Run Aggregate Supply Curve

◦ SRAS is upward sloping

◦ Suppliers are willing to
supply more RGDP at
higher price levels and
less at lower price
levels, ceteris paribus.

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 9.1 The Aggregate Supply Curve
 Why is the short-run aggregate supply curve
positively sloped?
◦ Two reasons producers are willing to supply more output
when the price level increases:
 the profit effect, and
 the misperception effect.

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 9.1 The Aggregate Supply Curve
 Short-run profit effect:
◦ Input costs are slow to adjust due to long-term contracts.
◦ When price level rises, producers are able to increase
output prices relative to cost.
◦ This increases producers’ short-run profit margins, making
it profitable to expand production and sales at higher price
levels.

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 9.1 The Aggregate Supply Curve
 The Misperception effect:
◦ Producers can be fooled into thinking the relative price
of their product has increased, so they supply more
based on the short-run misperception of relative prices.
◦ However, it may simply be that the general price level
has increased.

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9.1 The Aggregate Supply Curve
Exhibit 2a: The Long-Run Aggregate Supply Curve
o An economy’s stock of
resources and level of
technology define the
position of its production
possibilities curve (PPC),
as illustrated in part (a).

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 9.1 The Aggregate Supply Curve
 Why is the long-run aggregate supply curve vertical at
the natural rate of output?
◦ In the long-run:
 the level of RGDP that producers are willing to supply is not
affected by changes in the price level.
 firms will always produce at the maximum level allowed by
their resources, regardless of the price level.
◦ Therefore, the LRAS curve is vertical.

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9.1 The Aggregate Supply Curve
Exhibit 2b: The Long-Run Aggregate Supply Curve
o The position of the LRAS curve
is determined by the natural
rate of output, RGDPNR, which
reflects the levels of capital,
land, labour, and technology in
the economy.

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 9.1 The Aggregate Supply Curve
 Section Check
◦ The aggregate supply curve is the relationship between the
overall price level and the total quantity of final goods and
services that suppliers are able and willing to produce.

◦ The short-run aggregate supply curve measures how much

RGDP suppliers are willing to produce at different price
levels when input prices are unable to adjust.

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 9.1 The Aggregate Supply Curve
 Section Check [cont’d]
◦ For this reason, producers can make a profit by
expanding production when the price level rises.
◦ Producers may be fooled into thinking that the
relative price of the item they produce is rising, so
they increase production.

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 9.1 The Aggregate Supply Curve
 Section Check [cont’d]
◦ In the long run, the aggregate supply curve is vertical.
◦ In the long run, input prices change proportionally with
output prices.
◦ The position of the LRAS curve is determined by the level
of capital, land, labour, and technology at the natural rate
of output, RGDPNR.

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 9.2 Shifts in the Aggregate Supply Curve
 This section will answer the following key questions:
◦ What factors of production affect the short-run and the
long-run aggregate supply curves?
◦ What factors exclusively shift the short-run aggregate
supply curve?
◦ Can we review the determinants that change aggregate
supply?

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 9.2 Shifts in the Aggregate Supply Curve
 What factors of production affect the short-run
and long-run aggregate supply curves?
◦ Any change in the quantity of any factor of production
(capital, land, labour, or technology) can shift both the
long-run and short-run aggregate supply curves.

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 9.2 Shifts in the Aggregate Supply Curve
Exhibit 1: Shifts in Both Short-Run and Long-Run
Aggregate Supply
◦ Increases in any of the factors
of production (capital, land,
labour, or entrepreneurship)
can shift both the LRAS and
SRAS curves to the right.

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 9.2 Shifts in the Aggregate Supply Curve
 How capital affects aggregate supply
◦ Changes in the stock of capital will alter the amount of
goods and services the economy can produce.
◦ Investment in capital improves the quantity and quality
of capital stock and lowers the cost of production in the
short run.
◦ Allows output to be permanently greater than before.

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 9.2 Shifts in the Aggregate Supply Curve
 How capital affects aggregate supply [cont’d]
◦ Changes in human capital can also alter the AS curve.
◦ Investment in education or on-the-job training causes
productivity to rise.
◦ Shifts both SRAS and LRAS to the right.
 More skilled workforce lowers cost and shifts SRAS.
 LRAS shifts rightwards because greater output is
achieved on a permanent/sustainable basis.

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 9.2 Shifts in the Aggregate Supply Curve
 How Land Affects Aggregate Supply
◦ Land includes all natural resources.
◦ Increase in available natural resources will lower
production costs and expand output.
◦ This will shift both SRAS and LRAS rightwards.
◦ Decrease in natural resources reduces output.

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 9.2 Shifts in the Aggregate Supply Curve
 How Labour Force Affects Aggregate Supply.
◦ Increases in labour force tend to depress wages and
increase short-run aggregate supply.
◦ An expanded labour force also increases the economy’s
potential output, which increases the long-run aggregate
supply.

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 9.2 Shifts in the Aggregate Supply Curve
 How Technology and Entrepreneurship Affect
Aggregate Supply.
◦ Innovative technology leads to cost savings and expanded
output possibilities.
◦ Shifts both SRAS and LRAS to the right.

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 9.2 Shifts in the Aggregate Supply Curve
 What factors of production affect the short-run and
long-run aggregate supply curves? [cont’d]
◦ Government Regulations:
◦ A reduction in government regulations lowers the costs
of production.
◦ Potential real output expands, causing both the SRAS
and LRAS curves to shift to the right.

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 9.2 Shifts in the Aggregate Supply Curve
 What factors of production affect the short-run and
long-run aggregate supply curves? [cont’d]
◦ Some factors shift SRAS but do not impact the LRAS:
 Wages and other input prices
 Productivity
 Unexpected supply shocks

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 9.2 Shifts in the Aggregate Supply Curve
Exhibit 2: Shifts in SRAS but Not LRAS
◦ A change in input prices that
does not reflect a permanent
change in the supply of those
inputs will shift the SRAS
curve but not the LRAS curve.

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 9.2 Shifts in the Aggregate Supply Curve
 How wages and other input prices shift the SRAS curve
◦ Supply and demand in factor markets cause input prices
to change.
◦ Change in input price will affect only SRAS if they don’t
reflect permanent changes in the supplies of some factors
of production.

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 9.2 Shifts in the Aggregate Supply Curve
 How wages and other input prices shift the SRAS curve
[cont’d]
◦ For example, a wage hike without a corresponding increase
in productivity will make production more costly.
◦ SRAS shifts left.
◦ With the same supply of labour as before, potential output
(LRAS) does not change.

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 9.2 Shifts in the Aggregate Supply Curve
 How temporary supply shocks shift the SRAS curve
◦ Unexpected temporary events can either increase or
decrease aggregate supply.
◦ Negative supply shocks can increase production costs and
shift SRAS to the left.
◦ Positive supply shocks (e.g., favourable weather) can
reduce production costs and shift SRAS to the right.

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 9.2 Shifts in the Aggregate Supply Curve
 How temporary supply shocks shift the SRAS curve
[cont’d]
◦ Once the temporary effects have been felt, no real change
in the economy’s productive capacity has occurred.
◦ As a result, the long-run aggregate supply curve does not
shift.

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 9.2 Shifts in the Aggregate Supply Curve
 Exhibit 3: Factors That Shift Either the SRAS Curve, the
LRAS Curve, or Both

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 9.2 Shifts in the Aggregate Supply Curve
 Exhibit 3: Factors That Shift Either the SRAS Curve, the
LRAS Curve, or Both

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 9.2 Shifts in the Aggregate Supply Curve
 Section Check
◦ Any increase in the quantity of any of the available factors
of production (capital, land, labour, or entrepreneurship)
will cause both the long-run and short-run aggregate
supply curves to shift to the right.
◦ A decrease in any of these factors will shift both of the
aggregate supply curves to the left.

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 9.2 Shifts in the Aggregate Supply Curve
 Section Check [cont’d]
◦ Changes in wages and other input prices, productivity,
and temporary supply shocks shift the short-run
aggregate supply curve but do not affect the long-run
aggregate supply curve.

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 9.2 Shifts in the Aggregate Supply Curve
 Section Check
[cont’d]

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 9.3 Macroeconomic Equilibrium
 This section will answer the following key questions:
◦ How is macroeconomic equilibrium determined?
◦ What are recessionary and inflationary gaps?
◦ How can the economy self-correct to a recessionary gap?
◦ How can the economy self-correct to an inflationary gap?

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 9.3 Macroeconomic Equilibrium
 How is Macroeconomic Equilibrium Determined?
◦ The short-run equilibrium levels of real output and price
are shown by the intersection of the AD and SRAS curves.
◦ When this equilibrium occurs at the potential output level,
the economy is operating at full employment on the LRAS.
◦ Only at this point is the economy in a long-run equilibrium.

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 9.3 Macroeconomic Equilibrium
Exhibit 1: Long-Run Macroeconomic Equilibrium
◦ Long-run macroeconomic
equilibrium occurs at the
level where the SRAS
and Aggregate Demand
curves intersect at a
point on the LRAS curve.

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 9.3 Macroeconomic Equilibrium
 How is macroeconomic equilibrium determined?
◦ Short-run equilibrium can change when the AD or SRAS
curve shifts right or left.
◦ the long-run equilibrium level of RGDP only changes when
the LRAS curve shifts.
◦ Shocks: Unexpected changes to aggregate supply or
aggregate demand.

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 9.3 Macroeconomic Equilibrium
 Exhibit 2: Actual and Potential RGDP, Canada 1981–2017

o Point A: Economic Boom

Actual RGDP > Potential RGDP

o Point B: Recession
Actual RGDP < Potential RGDP

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 9.3 Macroeconomic Equilibrium
 What are recessionary and inflationary gaps?
◦ Equilibrium can occur at less than the potential output of
the economy.
◦ Recessionary gap: An output gap that occurs when the
actual output is less than the potential output.
◦ AD is insufficient to fully employ all of society’s resources.
◦ Unemployment is above the natural rate.

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 9.3 Macroeconomic Equilibrium
Exhibit 3a: Recessionary Gap
◦ The economy is currently in
short-run equilibrium at ESR.
◦ At this point, RGDP0 is less than
RGDPNR; that is, the economy is
producing less than its potential
output and the economy is in a
recessionary gap.

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 9.3 Macroeconomic Equilibrium
Exhibit 3b: Long-Run Equilibrium
◦ The economy is producing its
potential output at RGDPNR.
◦ At this point, the economy is in
long-run equilibrium and is not
experiencing an inflationary or
recessionary gap.

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 9.3 Macroeconomic Equilibrium
 What are recessionary and inflationary gaps? [cont’d]
◦ Inflationary gap: An output gap that occurs when the
actual output is greater than the potential output.
◦ AD is so high that the economy is temporarily operating
beyond full capacity.
◦ Leads to inflationary pressure.
◦ Unemployment is below the natural rate.

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 9.3 Macroeconomic Equilibrium
Exhibit 3c: Inflationary Gap
◦ The economy is currently in
short-run equilibrium at ESR.
◦ The economy is temporarily
producing more than its
potential output and we have
an inflationary gap.

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 9.3 Macroeconomic Equilibrium
 What are recessionary and inflationary gaps? [cont’d]
◦ Demand-pull inflation: A price level increase due to an
increase in aggregate demand.
 Causes an increase in the price level and an increase in real
output.
 Leads to an expansionary gap in the short run; unsustainable
in the long run.

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9.3 Macroeconomic Equilibrium
Exhibit 4: Demand-Pull Inflation

◦ Demand-pull inflation
occurs when the aggregate
demand curve shifts to the
right along the short-run
aggregate supply curve.

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 9.3 Macroeconomic Equilibrium
 What are recessionary and inflationary gaps? [cont’d]
◦ Cost-push inflation: A price level increase due to a
negative supply shock or increased input prices.
◦ Stagflation: Lower growth and higher prices occurring
together.
 Can be caused by a leftward shift in SRAS resulting from
supply shock.

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 9.3 Macroeconomic Equilibrium
Exhibit 5: Cost-Push Inflation
◦ Cost-push inflation is
caused by a leftward
shift in the short-run
aggregate supply curve,
from SRAS0 to SRAS1.

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 9.3 Macroeconomic Equilibrium
 What are recessionary and inflationary gaps? [cont’d]
◦ A decrease in AD can also cause a recessionary gap.
 If consumer confidence plunges, households will buy
fewer goods and services at every price level.
 This fall in AD will cause output and price level to fall.
 Unemployment will increase.

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9.3 Macroeconomic Equilibrium
Exhibit 6: Short-Run Decrease in Aggregate Demand
◦ A fall in aggregate
demand from a drop in
consumer confidence
can cause a short-run
change in the economy.

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 9.3 Macroeconomic Equilibrium
 How can the economy self-correct to a recessionary
gap?
◦ Many recoveries from a recessionary gap occur because
AD increases as a result of increased consumer/business
confidence, lower taxes, and/or lower interest rates.
◦ A rightward shift of the AD curve takes the economy back
to potential output.

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 9.3 Macroeconomic Equilibrium
 How can the economy self-correct to a recessionary
gap? [cont’d]
◦ The economy could self-correct through declining wages and
prices.
◦ At lower output, firms lay off workers.
◦ They may cut prices to increase sales.
◦ Unemployed workers and other input suppliers may bid down
wages and prices.

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 9.3 Macroeconomic Equilibrium
 How can the economy self-correct to a recessionary
gap? [cont’d]
◦ Reduced costs of production shift SRAS back to potential
output.
◦ The economy eventually returns to a long-run equilibrium at
a lower price level.

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9.3 Macroeconomic Equilibrium
Exhibit 7: Self-Correcting to a Recessionary Gap
◦ At point E1, the economy is in a
recessionary gap.
◦ However, the economy may self-
correct as labourers and other
input suppliers are now willing to
accept lower wages and prices for
the use of their resources.

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 9.3 Macroeconomic Equilibrium
 Self-correction to a recessionary gap can be slow
◦ Wage and price inflexibility: The tendency for downward
wage and price adjustments to respond slowly to changes
in the economy.
◦ This may lead to prolonged periods of a recessionary gap.
◦ Wages and prices are sticky downwards for several
reasons.

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 9.3 Macroeconomic Equilibrium
 Self-correction to a recessionary gap can be slow
[cont’d]
◦ Firms may be unable to cut wages due to long-term
contracts or minimum wage laws.
◦ Efficiency wages: Higher-than-equilibrium wages may
attract more productive workers, reduce turnover, and
improve morale.
◦ A higher wage causes a greater quantity of labour to be
supplied, leading to more unemployment.

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 9.3 Macroeconomic Equilibrium
 Self-correction to a recessionary gap can be slow
[cont’d]
◦ Menu costs: The costs of changing posted prices.
◦ Some firms may change prices only gradually to minimize
menu costs (price lists, catalogues, brochures, etc.).
◦ Their prices may, as a result, become too high.
◦ Sales and output fall.

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 9.3 Macroeconomic Equilibrium
 How can the economy self-correct to an inflationary
gap?
◦ Workers’ and input suppliers’ purchasing power declines as
output prices rise.
◦ They demand higher prices for their inputs.
◦ The SRAS curve shifts to the left until long-run equilibrium
is restored at LRAS.

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 9.3 Macroeconomic Equilibrium
Exhibit 8: Self-Correction to an Inflationary Gap
o The economy is in an inflationary
gap at E1, where RGDP0 is greater
than RGDPNR.
o Because the price level is now
higher than workers anticipated
(i.e., it is PL1 rather than PL0),
workers and other suppliers demand
higher prices.

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 9.3 Macroeconomic Equilibrium
 Price level and RGDP over time
◦ RGDP and price level have been rising due to increases in:
 Aggregate demand
 growing population, rising income, increased government
purchases, and increased money supply
 Aggregate supply
 increased labour force and improvements in labour productivity
and technology

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 9.3 Macroeconomic Equilibrium
 Exhibit 9: Canadian RGDP And Price Level, 1981–2017

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 9.3 Macroeconomic Equilibrium
 Section Check
◦ Short-run macroeconomic equilibrium is shown by the
intersection of the aggregate demand curve and the
short-run aggregate supply curve.
◦ A short-run equilibrium is also a long-run equilibrium
only if it occurs at the potential output on the long-run
aggregate supply curve.

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 9.3 Macroeconomic Equilibrium
 Section Check [cont’d]
◦ If short-run equilibrium occurs at less than the potential
output of the economy, RGDPNR, there is a recessionary
gap.
◦ If short-run equilibrium temporarily occurs beyond RGDPNR,
there is an inflationary gap.
◦ It is possible for the economy to self-correct from a
recessionary gap through declining wages and prices.

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 9.3 Macroeconomic Equilibrium
 Section Check [cont’d]
◦ The short-run aggregate supply curve eventually increases,
returning the economy to the long-run equilibrium (RGDPNR)
at a lower price level.
◦ It is possible for the economy to self-correct from an
inflationary gap through increasing wages and prices.

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 9.3 Macroeconomic Equilibrium
 Section Check [cont’d]
◦ The short-run aggregate supply curve ultimately decreases,
returning the economy to the long-run equilibrium (RGDPNR)
at a higher price level.

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