Chapter 10: Bringing in the Supply Side: Unemployment and Inflation

shows, for each possible price level, the quantity of goods and services that all the nation's businesses are willing to produce during a specified period of time, holding all other determinants of aggregate quantity supplied constant

- normally slopes upward to the right
because the costs of labor and other inputs remain relatively fixed in the short run, meaning that higher selling prices make input costs relatively cheaper and therefore encourage greater production
- position of aggregate supply curve can be shifted by changes in money wage rates, prices of other inputs, technology, or quantities or qualities of labor and capital

Producers are motivated by profit:
Unit Profit = Price - Unit Cost
- firms decide how much to produce by comparing their selling prices with their costs of production
- selling prices rise and nominal wages and other factor costs are fixed = production becomes more profitable = firms will be able to produce more
EX: worker makes gadget in an hour, sells for $9, workers earn $8/hour
Unit Profit = Price - Unit Cost
$9 - $8 = $1

Slopes Upwards because - production rises when price level rises, and falls when price level falls

1) The Nominal Wage Rate
- the aggregate supply shifts to the left (or inward) when nominal wages rise
- an increase in nominal wage shifts the aggregate supply curve inward -> quantity supplied at any price level declines.
- decrease in nominal wage shifts aggregate supply curve outwards -> quantity supplied at any price level increases

2) Prices of Other Inputs
- the aggregate supply curve is shifted to the left (or inward) by an increase in price of any input to the production process, and it is shifted to the right (or outward) by any decrease

3) Technology and Productivity
- Improvements in productivity shift the aggregate supply curve outward

4) Available Supplies of Labor and Capital
- as the labor force grows or improves in quality, and as investment increases the capital stock, the aggregate supply curve shifts outwards to the right, meaning that more output can be produced at any given price level

is the amount of output produced by a unit of input
- production rises when price level rises, and falls when price level falls

X-Graph (Supply and Demand)
(higher than equilibrium) = when aggregate quantity supplied would exceed aggregate quantity demanded -> surplus of goods -> inventories pile up -> prices and production would go down (so more people would buy)

SUPPLY EXCEEDS DEMAND -> PRICES GO DOWN

(lower than equilibrium) = quantity demanded would exceed quantity supplied -> shortage of goods -> inventories disappear -> price level and output rises (so less people would buy)

DEMAND EXCEEDS SUPPLY = PRICES GO UP

Inflation reduces the size of the multiplier
- Demand Side Multiplier Effect = one person's spending becomes another person's income, which leads to further spending by the second person, and so on
- As long as the aggregate supply curve slopes upward, any increase in aggregate demand will push up the price level. Higher prices, in turn, will drain off some of the higher real demand by eroding the purchasing power of consumer wealth and by reducing net exports. Thus, inflation reduces the value of the multiplier below what is suggested by the oversimplified formula
- As long as the aggregate supply curve slopes upward, any outward shift of the aggregate demand curve will increase the price level

is the amount by which equilibrium real GDP exceeds the full-employment level of GDP (potential GDP)
ex: aggregate demand is so high that the economy reaches an equilibrium beyond potential GDP

is the amount by which the equilibrium level of real GDP falls short of potential GDP
- could be caused by inadequate consumer spending or low investment spending
ex: wages may fall, shifting aggregate supply curve outward, but as the supply curve shifts to the right, prices decline and the recessionary gap shrinks

Why Nominal Wages and Prices Wont Fall (Easily)

When aggregate demand is low (because prices and wages are high), the economy may get stuck with a recessionary gap for a long time. If wages and prices fall very slowly, the economy will endure a prolonged period of production below potential GDP.

refers to the way money wages react to either a recessionary gap or an inflationary gap. Wage changes shift the aggregate supply curve and therefore change equilibrium GDP and the equilibrium price level
- a weak labor market reduces wage increases -> (may) drive wages down
- lower wages shift the aggregate supply curve outward, but it happens very slowly
- eliminates either recessionary gaps (unemployment) or inflationary gaps
- we do have a self-correcting mechanism but it happens very slowly; therefore, government action is considered

If aggregate demand is exceptionally high, the economy may reach a short-run equilibrium above full employment (inflationary gap). When this occurs, labor market forces nominal wages to rise. Rising wages increase business costs, prices increase; there is inflation. As higher prices cut into purchasing power and net exports, the inflationary gap begins to close.

is inflation that occurs while the economy is growing slowly or having a recession
- the normal aftermath of a period of excessive aggregate demand
1) economy will temporarily produce beyond its normal capacity
2) labor markets tighten and wages rise
3) machinery and raw materials may become scarce and start rising in price
4) making costs higher
5) making business firms produce less and charge higher prices = stagflation

- stagflation is the typical result of unfavorable shifts of the aggregate supply curve
- typical results of an unfavorable supply shock are lower output and higher inflation.
- unfavorable supply shocks tend to push unemployment and inflation up at the same time

- for any given growth rate of aggregate supply, a FASTER growth rate of aggregate demand will lead to more inflation and FASTER growth of real output
- for any given growth rate of aggregate supply, a SLOWER growth rate of aggregate demand will lead to more inflation and SLOWER growth of real output

if fluctuations in economic activity emanate mainly from the supply side, higher rates of inflation will be associated with lower rates of economic growth

equilibrium price level and equilibrium level of real GDP are jointly determined by the intersection of the economy's aggregate supply and aggregate demand schedules
- equilibrium of aggregate supply and demand can come at:
1) full employment
2) below full employment (recessionary gap)
3) above full employment (inflationary gap)