Understanding Aggregate Supply and Economic Impacts

Aggregate Supply (AS) curve

It describes the quantity of goods and services businesses are willing to produce at each price level, holding other factors constant.

Upward sloping AS curve

Because higher prices lead to higher profits, encouraging firms to produce more.

Unit profit

Unit profit = Price per unit - Unit cost.

Firms increase quantity supplied

Because profits per unit increase while input costs remain sticky.

Sticky input costs

Input prices like wages and raw materials that adjust slowly due to contracts or market rigidities.

Evidence of sticky wages

Only 5-20% of workers experience a wage change per quarter (Barattieri et al., 2010).

Sticky raw material prices

70% of firms have pre-arranged raw material contracts (Inverto, BCG report).

Sticky capital costs

Loan rates are based heavily on past rates and adjust slowly.

Flexible input prices

Energy prices, which often change monthly.

AS curve shifts

Changes in nominal wages, input prices, productivity, and labor/capital supply.

Increase in nominal wages effect on AS

It raises production costs, shifting AS leftward.

Technology effect on AS curve

It shifts AS rightward by lowering production costs.

Increased labor force or capital stock effect on AS

It shifts AS outward/rightward, boosting potential output.

AD shifts rightward without AS increase

Inflation occurs due to supply not keeping up with demand.

Inflation effect on spending multiplier

It weakens it by eroding purchasing power and hurting net exports.

Firms' response to higher spending

By raising output or raising prices.

Recessionary gap

When actual GDP is less than full-employment GDP.

Inflationary gap

When actual GDP exceeds full-employment GDP.

Expenditure schedule

Determines equilibrium GDP at a fixed price level.

AD-AS model

Determines both equilibrium GDP and the price level.

Economic trends 1972-2007

Systematic inflation and real GDP growth.

Economic events 2008-2010

Minor inflation (even deflation) and lower GDP.

Economic events 2010-2017

Inflation and rising GDP resumed.

Long-run AS curve

In the long run, output is determined by resources and technology, not prices.

Tech breakthrough effect on AS curve

AS shifts rightward; GDP increases and price level may fall or rise more slowly.

Wages are sticky; prices rise sharply

Profits rise; firms increase production in the short run.

$500B stimulus effect

It reduces the actual GDP gain compared to predictions.

Equilibrium GDP vs Full-employment GDP

Recessionary gap; use expansionary fiscal policy.

War triples oil prices effect

AS shifts left; prices rise, GDP falls.

Energy prices adjust faster than wages

Energy costs rise first, squeezing short-run profits before wage adjustments catch up.

Events shifting AS left and right

Left: wage hike or resource scarcity; Right: tech improvement or labor supply growth.

Multiplier with MPC = 0.8

Multiplier = 5; GDP increases by $500B.

Measured multiplier smaller than predicted

Inflation, import leakages, and reduced consumer response shrink the real multiplier.

Short-run AS vs long-run AS

Short run reflects price-output link; long run reflects full employment and resource limits.

AD shift from D₀ to D₁

Price level rises (inflation) and real GDP rises.

$200B investment output change with MPC = 0.75

$800B increase.

Actual output increase shown in diagram

Only $400B due to inflation.

Inflation effect on multiplier's effectiveness

It reduces purchasing power and foreign demand.

Points E₀ and E₁

Initial and new equilibrium points after AD shift.

Flat AS curve after AD shift

Minimal inflation and larger GDP increase.