Chapter 10: Bringing in the Supply Side – Aggregate Supply, Unemployment, and Inflation

Bringing in the Supply Side: Unemployment and Inflation

Introduction

This chapter completes the basic macroeconomic model by introducing the aggregate supply curve, which, together with aggregate demand, determines both the price level and output in a private economy. The chapter also sets the stage for considering government intervention through macroeconomic policy.

• Main questions addressed:

  • Does the economy have an efficient self-correction mechanism?

  • What causes stagflation?

The Aggregate Supply Curve

Definition and Properties

The aggregate supply curve illustrates the relationship between the price level and the quantity of real GDP supplied, holding all other determinants of quantity supplied constant. It typically slopes upward, indicating a positive relationship between price and aggregate quantity supplied.

• Why does the aggregate supply curve slope upwards?

  • Firms are motivated by profit: $ext{Unit Profit} = ext{Price} - ext{Unit Cost}$

  • Some input costs (e.g., wages, materials) are fixed by contract for a period of time, so as prices rise, profits increase, encouraging firms to supply more.

• Example: If the price level rises but wages are fixed by contract, firms' profits increase, leading to greater output.

Graphical Representation

Figure 1 shows the aggregate supply curve as an upward-sloping line, with price level on the vertical axis and real GDP on the horizontal axis.

Shifts of the Aggregate Supply Curve

The aggregate supply curve can shift due to changes in several factors:

• Nominal wage rate: Higher wages increase production costs, reduce profits, and shift aggregate supply left (decrease supply).

• Prices of other inputs: Increases in input prices (e.g., energy, oil) have similar effects as wage increases.

• Technology and productivity: Improvements reduce business costs and shift aggregate supply right (increase supply).

• Available supplies of labor and capital: Growth in labor force or capital stock increases aggregate supply.

Table: Factors Affecting Aggregate Supply

Factor	Effect on Aggregate Supply
Nominal wage rate	Higher wages shift supply left; lower wages shift supply right
Prices of other inputs	Higher input prices shift supply left; lower prices shift supply right
Technology/Productivity	Improvements shift supply right
Labor and Capital	Increases shift supply right

Equilibrium of Aggregate Demand and Supply

Determination of Equilibrium Price Level and Real GDP

Equilibrium occurs where the aggregate demand curve intersects the aggregate supply curve. At this point:

• The equilibrium price level is determined.

• Aggregate quantity demanded equals aggregate quantity supplied.

Table: Determination of the Equilibrium Price Level

Price Level	Aggregate Quantity Demanded	Aggregate Quantity Supplied	Balance of Supply and Demand	Prices will be
80	6,400	5,600	Demand exceeds supply	Rising
90	6,200	5,800	Demand exceeds supply	Rising
100	6,000	6,000	Demand equals supply	Unchanged
110	5,800	6,200	Supply exceeds demand	Falling
120	5,600	6,400	Supply exceeds demand	Falling

Inflation and the Multiplier

Impact of Inflation on the Multiplier

Inflation reduces the size of the multiplier. When the aggregate supply curve is upward sloping, increases in aggregate demand raise the price level, which erodes consumer wealth and reduces net exports, thus dampening the effect of the multiplier.

• Any outward shift of aggregate demand will cause some rise in prices if aggregate supply slopes upward.

Recessionary and Inflationary Gaps

Definitions

• Inflationary gap: The amount by which equilibrium real GDP exceeds the full-employment level of GDP.

• Recessionary gap: The amount by which equilibrium real GDP falls short of potential GDP.

Three Possible Cases

1. Aggregate demand intersects aggregate supply at potential GDP: Economy is 'just right'.

2. Aggregate demand intersects aggregate supply below potential GDP: Recessionary gap.

3. Aggregate demand intersects aggregate supply above potential GDP: Inflationary gap.

Adjusting to a Recessionary Gap: Deflation or Unemployment

Mechanism and Challenges

• When equilibrium real GDP is less than potential GDP, cyclical unemployment occurs.

• If unemployment persists, wages may fall, shifting aggregate supply right and increasing real GDP while lowering the price level.

• However, in reality, this process can take a long time and deflation is rare in the U.S.

• Institutional factors (minimum wage, unions, regulations) and psychological resistance to wage reduction slow the adjustment.

• With low aggregate demand, the economy can get stuck in a recessionary gap with persistent high unemployment.

Adjusting to an Inflationary Gap: Inflation

Mechanism

• When equilibrium real GDP exceeds potential GDP, labor is in great demand and firms increase wages.

• Higher wages increase costs, shifting aggregate supply left and returning the economy to potential GDP at a higher price level.

Demand Inflation and Stagflation

• Demand inflation: Occurs when excessive aggregate demand leads to higher wages and prices.

• Stagflation: Inflation that occurs while the economy is growing slowly or in recession, often due to a decrease in aggregate supply.

Stagflation for a Supply Shock

Causes and Effects

• Stagflation can result from:

  • A decrease in aggregate supply as the economy adjusts to an inflationary gap.

  • Negative supply shocks, usually energy price increases (e.g., OPEC oil embargoes, wars, demand from China).

• Higher energy prices cause aggregate supply to decrease, leading to lower real output and higher price levels.

Applying the Model to a Growing Economy

Long-Term Trends

• In the real world, both the price level and real GDP rise over time.

• Aggregate demand and supply shift right annually due to population growth, increased government purchases, more workers, and improved technology.

• Demand-side fluctuations: Faster growth in aggregate demand leads to more inflation and faster output growth.

• Supply-side fluctuations: Negative supply shocks lead to inflation and reduced output growth; favorable supply shocks increase output and reduce inflation.

A Role for Stabilization Policy

Government Intervention

• Investment spending is volatile and changes in spending have multiplier effects on aggregate demand.

• Shifts in aggregate demand cause fluctuations in real GDP and the price level.

• The economy's self-correcting mechanism works, but slowly.

• Government stabilization policy can help:

  • Fiscal policy: Government spending and taxation.

  • Monetary policy: Central bank actions affecting money supply and interest rates.

Some Important Definitions

• Aggregate Supply Curve: 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, holding other determinants of aggregate quantity supplied constant.

• Productivity: The amount of output produced by a unit of input.

• Inflationary Gap: The amount by which equilibrium real GDP exceeds the full-employment level of GDP.

• Recessionary Gap: The amount by which equilibrium real GDP falls short of potential GDP.

• Self-Correcting Mechanism: The tendency of an economy to eliminate either a recessionary gap or an inflationary gap through changes in money wages that shift aggregate supply.

• Stagflation: Inflation that occurs while the economy is growing slowly or having a recession.

Additional info: The notes have been expanded with academic context, definitions, and examples to ensure completeness and clarity for exam preparation.