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Aggregate Supply

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, aggregate supply represents the ability of an economy to produce goods and services either in the short-term or in the long-term. It tells us the quantity of real GDP that will be supplied at various price levels. The nature of this relationship will differ between the long run and the short run
•In the long run, the aggregate-supply curve is assumed to be vertical
•In the short run, the aggregate-supply curve is assumed to be upward sloping

Crowding Out

Gov't spends or borrows too much money too fast and interest rates get too high. Occurs when high interest rates caused by too much gov't borrowing decrease private sector investments

Crowding out tends to

Increased government borrowing tends to increase market interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow. So it leads to a decrease in investments by private companies and people.

Contractionary Policy could lead to

Crowding in. Consumers actually spend more and private companies spend more because of a decrease in gov't spending

Crowding in

the situation in which decreases in government spending lead to increases in private spending

Fiscal Policy and Aggregate Supply



a period in which nominal wages and other input prices do not respond to price-level changes

Two reasons why nominal wages do not respond to changes in the price-level in the SHORT RUN

1)Workers may not immediately be aware of the extent to which inflation (price-lvl) has changed their real wages, thus may not be able to adjust their demands accordingly
2)Many employees are hired under FIXED wages for at least a couple years

Long Run

period where nominal wages are fully responsive to previous changes in the price level, (when workers finally receive info about the changes in price-lvl and adjust their spending accordingly)


Is affected by changes in the price-lvl

A decrease in price-lvl (deflation) affects output and employment in what way?

Decreases output and increases unemployment. (because business want to supply less @ lower prices and then lay off workers.

An increase in price-lvl (inflation) affects output and employment in what way?

Increases output/production and because they extend work hours of employees, news workers and those structurally unemployeed get motivated. Leads to a decrease in unemployment below its natural rate.

Outcomes are different in the Long Run however


A movement along the SRAS curve is caused by

A change in the price-lvl solely, ceteris paribus

Most important single cause of a shift in the SRAS

is a change in wage rates.

Shift in the SRAS

Caused by changes in the wage rates or other cost of inputs

Higher wage rates or increases in cost of production cause the SRAS to decrease because

Higher wage rates, without any increase in labour productivity to compensate for it, cause a rise in production costs, leading businesses to produce less and the aggregate supply curve will shift to the left

Lower wage rates and decreases in cost of production causes to SRAS to increase because

a fall in raw material prices or component costs will reduce production costs, encouraging firms to produce more and the short run aggregate supply curve shifts to the right


inelastic of changes in the price-lvl (changes in price-lvl only affects supply in the short run)

The SRAS suggests and assumes

an increase in prices leads to a temporary increase in output as firms employ more workers and assumes that lvl of capital is fixed.

LRAS is affected by

all factors of production - size of workforce, size of capital stock, levels of education and labour productivity

An increase in investments or a growth in the size of the labor force would cause the LRAS to...

Shift to the right (

Building a new factory (new capital) would affect the SRAS or LRAS

LRAS supply because factories and most other capital cannot be build in the short-run.

Classical Economics says that the LRAS is inelastic so it is a vertical line

Keynsian Economics says the LRAS is elastic at a point up to inelastic. In a sense the Keynesian view is a combination of the short run aggregate supply and long run. The Keynesian LRAS shows that there is a point in the economy of spare capacity where firms can use more. There also comes a point where full capacity is reached.

Nominal wages

Wages based on current prices.

Nominal wages in the long run are

fully responsive to changes in the price lvl

Nominal wages in the short run are

unresponsive to changes in the price lvl

Real wages =

Nominal wages / price lvl

1)Price increase causes economy to move from point a1 to a2 on the SRAS which increases output. However, in the long run workers found out their real wages/what their money can buy has declined

3)They restore their previous lvl of real wages by increasing their nominal wages 4)Because wages now increase, the SRAS will shift to the left 5)Real output will then fall and unemployment will rise back to its natural lvl

So basically the long run effects of a price increase that causes a movement along the SRAS curve eventually leads to a

decrease in real output and increase in unemployment (because people would have to increase and restore their real wages in response to an increase in the price lvl SRAS will decrease)

Nominal means

not adjusted for inflation


vertical at full employment

Basically, the long run effect on supply due to a decrease in prices are

an increase in output and a decrease in unemployment

Extended AD/AS model includes

SRAS, AD and also LRAS. Equilibrium is where the AD curve intersects both the LRAS AND SRAS curves.

An increase in the price lvl eventually leads to..

increase in nominal wages; thus a leftward shift of the SRAS

Rise in net exports and increases in spending does what to AD

Increases Aggregate demand

When worker's wages decline, what happens to nominal wages

nominal wages increase

Demand-pull inflation effects in short run

Increases price-lvl and output in the short run

Demand-pull inflation effects in long run

Increases nominal wages and shifts SRAS curve leftwards. Real output returns to normal levels and price lvl rises even more. The economy re-establishes long run equilibrium (or full employment lvl of output)

Cost-push inflation arises from factors that increase the cost of production at each possible price lvl

which shifts the aggregate supply curve to the left and raises equilibrium price-lvl

Lower price lvls increases real wages for people because..

there is greater purchasing power due to lower inflation

When nominal wages fall, what happens to SRAS

Shifts to the right

A decline in AD: effects in the short run

reduces output

A decline in AD: effects in the long run

drops prices and and reduces nominal wages. SRAS shifts rightward. And real output returns to its full employment lvl

Aggregate supply shocks do what to inflation and unemployment

can lead to higher inflation and higher rates of unemployment

Tax cuts can lead to workers keeping more income and working harder because of that. This motivation, caused by low taxes, to earn money does what to GDP and AS

It can increase GDP and shift AS to the right. More people would want to join the labor force

Inside Lag

How long it takes the gov't and feds to make a policy

Outside Lag

How long it takes us on the outside to respond to policy changes

Inside lag for Feds and Gov't

1)Feds: Short Inside Lag 2)Gov't= Long because policies have to go through the house and senate etc

Outside Lag for Feds and Gov't

1)Feds= Long inside lag for monetary policies 2)Gov't=short for fiscal policies because when gov't proposes a policy, we've been hearing about it for a long time so we respond immediately

Phillips Curve

Shows the relationship between inflation and unemployment.

Basic Phillips Curve Idea

Short term economic trade-off between unemployment and inflation

SRPC (Short Run Phillips Curve)

Inverse relationship. Inflation rate on Y-axis. Unemployment rate on the Y-axis.

High rates of inflation are accompanied by

low rates of unemployment. (because high aggregate demand which creates more jobs leads to higher inflation)

It is impossible to achieve full employment w/o inflation

An Expansionary monetary or fiscal policy that boosted AD would lower the unemployment rate and simultaneously increase inflation


Period with both high inflation and high unemployment. High unemployment is also known as low outputs. Shifts SRPC curve outwards

Aggregate Supply Shocks and the Phillips Curve

ASS could lead to both higher inflation rates and higher unemployment. Shifts SRPC rightwards

Adverse Aggregate Supply Shocks

Sudden large increases in resource costs. Shifts SRAS curve leftwards. Increases both inflation via cost-push inflation and unemployment

Adverse aggregate supply shock could result from

Rapid rise in oil prices

When AD shifts to the right, inflation occurs and output increases, what happens to the phillips curve?

We move leftwards ALONG the phillips curve. No shift occurs to the phillips curve.

Outward shifts in Phillips curve

caused by adverse supply shocks like a rapid rise in oil prices. Or a rapid rise in input costs.

Favorable supply shocks (sharp drop in oil prices)

Shifts Phillips curve downwards or inwards

LRPC (Long Run Phillips Curve)

Vertical line. Shows that natural unemployment is always present. (frictional and structural)

LRPC shows that

there is no apparent long-run tradeoff between inflation and unemployment.

Natural Rate of Unemployment

Rate of unemployment when the economy achieves its potential output. Where cyclical unemployment is 0

When the actual rate of inflation is higher than expected,

Profits will temporarily rise and the unemployment temporarily falls

In the long run, after nominal wages catch up w/ price lvl increases, unemployment returns to its natural rate...what happens?

There is a new SRPC curve at the higher expected rate of inflation

Aggregate Demand =

C + I + G + (Net Exports)

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