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IFT Notes for Level I CFA® Program

R14 Aggregate Output, Prices and Economic Growth

Part 5



3.2. Aggregate Supply

Aggregate supply curve shows the relationship between domestic output and price level. In simple words, it shows the amount of goods and services firms will produce in an economy (real GDP) at each price level.

Aggregate Supply Curve

The graph below shows LRAS, SRAS and VRAS curves.

econ r16 3.2 1

Interpretation of the graph:

  • Plots real GDP on the x-axis (remember we had quantity in the microeconomics supply curve).
  • Plots price level on the y-axis.
  • Very short run: AS curve is almost flat. This is because companies increase or decrease output without changing prices.
  • Short run: In the short run, firms consider the price level to decide how much to produce. AS curve is upward sloping – a decrease in the price level reduces the quantity of goods and services supplied. Some costs such as labor and capital are sticky (fixed) in the short run. So, when prices increase, businesses can increase output as it is more attractive (given the high selling prices).
  • Long run: In the long run, the AS curve is vertical at a given level of output. Aggregate price has no effect on aggregate output because wages, prices and expectations adjust; firms do not decide how much to produce based on the price level. In the long run if prices are up, then costs such as wages also go up and in real terms, nothing has changed.
  • In the very long run, there is a shift in the LRAS when costs of production change: labor, capital, natural resources, technological advance, etc. This is discussed in section 4.

There is a distinction in the terms short run and long run as used in micro- and macroeconomics.

  • In microeconomics: in the short run, labor is variable, but capital is fixed.
  • In macroeconomics: in the short run, wages or some costs are sticky i.e. they do not change. In the long run, all costs change.

Example

What is the relationship between wages and the slope of the SRAS curve?

Solution:

Consider two scenarios: when wages are sticky, and when wages are not sticky.

Wages are sticky: when prices increase, output increases substantially. The slope of SRAS is flatter.

Wages are not sticky: when prices increase, the output does not increase much. The slope of SRAS is steeper.

3.3. Shifts in Aggregate Demand and Aggregate Supply

The graph below shows LRAS, SRAS and AD curves. This section and the next are based on the interaction of these three curves.

econ r16 3.3 1

Interpretation of the graph:

  • The output level at the intersection of the three curves is called the long run equilibrium level of output or natural level of output.
  • The output level is closely related to the level of employment. At the natural level of output, the economy is at the natural rate of unemployment.
  • Full employment does not mean 100% employment. It means that there is a natural level of unemployment, which includes people who are in between jobs. The percentage of people who are in between jobs is equal to the percentage of vacancies.

The objective of this section is to understand the interaction of the curves discussed above, what causes a shift in these curves, and to answer these important macroeconomic questions:

  • What causes an economy to expand and contract?
  • What causes changes in price level and unemployment?
  • What determines an economy’s rate of unsustainable growth?

Why are they important? Because GDP growth impacts corporate profits which, in turn, impacts stock prices.

Shifts in Aggregate Demand

In this section, we look at the factors that cause an aggregate demand curve to shift.

econ r16 3.3 2

Shift in the Aggregate Demand Curve
To determine shift in AD, use the equation C + I + G + (X – M)
An Increase in the following factors Shifts in the AD Curve Reason
Stock prices Right Higher consumption. This is also called the wealth effect. Increase in stock prices à increase in household wealth à need to save decreases as future goals are met à more income spent on consumption à shift in the demand curve.
Housing prices Right Higher consumption. Wealth effect.
Consumer confidence Right Consumers confident about future & job security à spend more of their disposable income.
Business confidence Right Companies optimistic about future growth prospects à increase in investments.
Capacity utilization Right Increase in investment spending if companies are operating at near or full capacity.
Government spending Right Increase in government spending (fiscal policy).
Taxes Left Higher taxes à lower disposable income à lower consumption. Lower investment spending by businesses.
Bank reserves Right More money supply. Interest rates are low. Investment is higher. Higher income and higher expenditure. Consumers hold real money balances.
Exchange rate Left Domestic currency is stronger. Lower exports. Higher imports. Net exports are lower.
Global growth Right Faster economic growth in foreign markets à foreign consumers buy domestic products à exports are higher. Net exports are higher.

Note: Government spending and taxes are part of fiscal policy. Bank reserves and the exchange rate are part of monetary policy. These are covered in the next two readings.

A few other points related to AD curve:

  • When the aggregate demand curve shifts to the right, in the very short run, output goes up while the price level stays the same.
  • In the long run, as wages and other costs adjust, the output is back to its initial equilibrium level.

Shifts in Aggregate Supply

In the AS curve, the price level is on the y-axis and output on the x-axis. The LRAS is a vertical line while the SRAS is a positively sloped curve. The factors in bold in the first column affect both the SRAS and the LRAS curve to shift, while the remaining factors affect only the SRAS curve.

Shift in the Aggregate Supply Curve (based on Exhibit 20 in the curriculum)
An Increase in the following factors Shifts SRAS Shifts LRAS Reason
Supply of labor Right Right Increases resource base. Labor supply depends on the labor participation rate, growth of population, etc.
Supply of natural resources Right Right Increases resource base.
Supply of human capital Right Right Increases resource base. Improvement in quality of labor.
Supply of physical capital Right Right More efficiency with better equipment à more output.
Productivity and technology Right Right Higher productivity à higher efficiency and amount of output produced by workers in a given time. Decreases labor cost; higher profitability.
Nominal wages Left No impact Largest component of a company’s costs are wages. Higher wages à higher labor cost.
Input prices Left No impact Increases cost of production.
Expectation of future prices Right No impact Anticipating higher future prices à higher profitability.
Business taxes Left No impact Increases cost of production.
Subsidy Right No impact Lowers cost of production.
Exchange rate Right No impact Lowers cost of production.

Many countries import raw materials. Ex: Japan. If the domestic currency is stronger, then imports are cheaper.

 

The position of the LRAS curve is determined by the potential output of the economy. Potential GDP measures the productive capacity of the economy and is the level of real GDP that can be produced at full employment.

3.4. Equilibrium GDP and Prices

Short-run macroeconomic equilibrium may occur at a level above or below full employment; there are four possible types of macroeconomic equilibrium:

  1. Long-run full employment.
  2. Short-run full employment.
  3. Short-run inflation gap.
  4. Short-run stagflation.

The price level and output at the point where AD and SRAS curves intersect is called the short-run macroeconomic equilibrium. At this point, the aggregate quantity demanded = aggregate quantity supplied. Let us denote the real GDP at equilibrium as Y1. If we are to the left of this point, then the level of unemployment is higher than the natural level of employment.

Long-run macroeconomic equilibrium:

The graph below shows a long-run macroeconomic equilibrium.

econ r16 3.4 1

  • In the long run, the intersection of AD and SRAS curve occurs at a point on the LRAS curve; this point is the equilibrium point.
  • At equilibrium, labor, and capital are fully employed. Unemployment is at its natural rate.
  • In the long run, equilibrium GDP = potential GDP.

Recessionary gap:

The graph below shows a recessionary gap.

econ r16 3.4 1

  • Assume for some reason, there is a leftward shift in the AD curve. It moves from AD1 to AD2.
  • This results in lower GDP and lower price levels.
  • The corresponding short-run equilibrium real GDP has moved from Y1 to Y2. The price level has come down from P1 to P2. As demand has gone down, companies reduce workforce, which leads to unemployment going up. We are now below the natural level of unemployment. This difference (Y2-Y1) is called the recessionary gap.
  • Equilibrium GDP is below the potential GDP.
  • The effects of a decline in AD are decline in corporate profits, commodity prices, interest rates, and demand for credit.

Inflationary gap:

The graph below shows an inflationary gap.

econ r16 3.4 1

  • This happens if the aggregate demand curve shifts to the right.
  • If the AD curve moves from AD1 to AD2, then output increases from Y1 to Y2. The price level moves from P1 to P2.The short-run equilibrium moves to the left. This gap between Y1 and Y2 is called the inflationary gap because it drives inflation. The economy is over-utilizing its resources – workers are putting in more hours.
  • At the new short-run equilibrium, GDP is above the potential GDP. As there is an upward pressure on prices, the company must pay higher wages and input prices to increase production.
  • The economy cannot remain at Y2 for long because people are working extra shifts and will demand higher wages. Eventual increase in prices will shift the SRAS to the left and the economy will return to potential GDP.
  • The effects of an increase in AD includes increase in corporate profits, commodity prices, interest rates, and inflationary pressures.

Stagflation:

The graph below shows a stagflation scenario.

econ r16 3.4 1

  • SRAS curve shifts to the left.
  • Output is down from Y1 to Y2. Unemployment level is below the natural level of unemployment. Price levels go up. In short, there is high unemployment and increased inflation.
  • Over time, reduced output will cause wages and input prices to decrease and shift SRAS to the right.

 

Example

The table below shows the effect of changes in AS and AD on real GDP. Fill the last two columns in the table below for different combinations of AD and AS in the first two columns.

Effect of changes in AD and/or AS
Change in AS Change in AD Effect on Real GDP Effect on Aggregate Price Level
Increase
Decrease
Increase
Decrease
Increase Increase
Decrease Decrease
Increase Decrease
Decrease Increase

Solution:

Change in AS Change in AD Effect on Real GDP Effect on Aggregate Price Level
Increase Increase. Lowers unemployment. Increase
Decrease Decrease. Increases unemployment. Decrease
Increase Increase. Lowers unemployment. Decrease
Decrease Decrease. Increases unemployment. Increase
Increase Increase Increase Indeterminate
Decrease Decrease Decrease Indeterminate
Increase Decrease Indeterminate Decrease
Decrease Increase Indeterminate Increase


Economics Aggregate Output, Prices, and Economic Growth Part 5