Aggregate Supply

In this section, we are going to look at the relationship between real GDP and the price level using the aggregate supply-aggregate demand model.

Aggregate Supply Definitions

Quantity of Real GDP Supplied: The total quantity of goods and services that firms want to produce in a specified time, valued in dollars (2005).

This quantity depends on the quantity of labors employed, human and physical capital, and their technological level. Human and physical capital, and technological level can be fixed in a specified time, but the quantity of labor can vary.

The labor market can be of three states:

1. Full Employment
2. Above Full Employment
3. Below Full Employment

At full employment, quantity of real GDP supplied equals potential GDP.

Aggregate Supply: the relationship between quantity of real GDP supplied and the price level.

The relationship between these two are different in two time frames: short-run and long-run. Therefore, we have two different types of aggregate supplies:

1. Short-run aggregate supply
2. Long-run aggregate supply

Short-Run Aggregate Supply

Short-Run Aggregate Supply: the relationship between quantity of real GDP supplied and the price level when the three following things are constant.

1. Potential GDP
2. Prices of other resources
3. Money Wage Rate

The following graph shows the Short-Run Aggregate Supply



In the graph, we see that

1. Price level $\, \uparrow \,$→$\,$ real GDP supplied $\, \uparrow$
2. Price level $\, \downarrow \,$→$\,$ real GDP supplied $\, \downarrow$
3. Upward sloping line (positive slope)

Why is the curve upward sloping? Well the more production there is, then the higher the marginal cost.


Long-Run Aggregate Supply

Long-Run Aggregate Supply: the relationship between quantity of real GDP supplied and price level when the money wage rate changes with price level to sustain full employment.

The following graph shows the Long-Run Aggregate Supply



In the graph, we see that

1. Vertical Line (slope is undefined)
2. Real GDP Supplied = Potential GDP
3. Price level & Money Wage Rate $\, \uparrow$ by same percentage

Shifts & Changes in Aggregate Supply

There are 2 influences that causes aggregate supply to shift:

1. Potential GDP
2. Money Wage Rate

Potential GDP: when potential GDP increases, it also increases long-run aggregate supply and short-run aggregate supply. They increase/shift by the same amount if we assume that full-employment price level remains constant.



There are three ways that potential GDP can increase.

1. Advance in technology: technological advances decrease the cost of production, so they can produce more even if they have a fixed capital and labor. Thus, this increase potential GDP.


2. Increase in full-employment quantity of labor: The bigger the quantity of labor, the bigger real GDP is. In addition, potential GDP increases because of the labor force is getting bigger.
   
   Note: If capital and technology is constant, potential GDP only increases if full-employment quantity of labor increases.


3. Increase in quantity of capital: the bigger the quantity of capital, the more productive the labor force becomes. This creates more production, thus increasing potential GDP.
   
   Note: Capital also includes human capital. People with more experience in producing the good will produce more of them than a person who has no experience.

Money Wage Rate: A rise in the money wage rate changes the short-run aggregate supply but does not change the long-run aggregate supply.



In the graph, we see that

1. Short-run aggregate supply shifts to the left: This is due to the increase in costs for the firm. It costs more to produce a good.


2. Long-run aggregate supply does not change: A change in money wage rate causes an equal percentage change in price level. The firm has no incentive to change production, so real GDP stays as potential GDP.