Understanding Aggregate Supply and Labor Market Dynamics in the AS-AD Model

We have seen how labor market equilibrium determines the quantity of labor employed, given a fixed amount of capital, other factors of production and the state of technology. Recall that the quantity of real GDP at full employment is potential GDP. Over the business cycle, real GDP fluctuates around potential GDP because the quantity of labor employed fluctuates around the full employment level. The aggregate supply-aggregate demand (AS-AD) model explains these fluctuations. Aggregate supply All other things remaining constant, the higher the price level, the greater is the quantity of real GDP supplied; the lower the price level, the smaller is the quantity of real GDP supplied. The aggregate supply curve shows the quantities of real GDP supplied at each price level: As we move along the AS curve, the only thing that can cause a change in the quantity of real GDP supplied is a change in the price level. E.g., if the price level increases from 115 to 130, real GDP increases from $9 trillion to $10 trillion. If the price level decreases from 115 to 100, real GDP decreases from $9 trillion to $8 trillion. When the price level is 115, the quantity of real GDP supplied is $9 trillion, which is potential GDP. Potential GDP is illustrated as a vertical line because it does not change when the price level changes. Potential GDP depends only on the economy’s ability to produce real output and on the full employment quantity of labor. Why does the AS curve slope upward? If the price level increases, the real wage rate decreases. Recall that, for an individual employer, Real wage rate = __________________________ Nominal wage rate Product price An increase in the price level means that product prices rise and the real wage rate falls. A fall in the real wage rate means that the firm’s cost of labor has decreased relative to the revenue an hour’s labor can produce, and therefore the firm’s profit increases. An increase in firms’ profits causes existing firms to increase their output rates and new firms to enter the industry and start producing. The quantity of real GDP supplied therefore increases. A decrease in the price level means falling product prices and rising real wage rates. Firms’ profits decrease. Firms respond by reducing their output rates and some firms exit the industry. The quantity of real GDP supplied therefore decreases. Shifts of the AS curve A shift of the AS curve is called a change in aggregate supply. A change in any factor, other than the price level, that affects production causes a shift in AS. Shifts in AS can be either increases or decreases in AS. An increase in AS means an increase in the quantity of real GDP supplied at each price level. The AS curve shifts to the right. A decrease in AS means a decrease in the quantity of real GDP supplied at each price level. The AS curve shifts to the left: The two main factors causing shifts of AS are: Changes in potential GDP Changes in the nominal wage rate or nominal prices of other resources A change in potential GDP: If potential GDP increases, the economy can produce more real GDP at full employment. But if the economy can produce more at full employment, it can also produce more at any level of employment. Therefore, if the potential GDP line shifts to the right, the entire AS curve also shifts to the right. If potential GDP decreases, the economy produces less at full employment and at all other levels of employment. The shift to the left of the potential GDP line is matched by a shift to the left of the AS curve. In effect, the potential GDP line “anchors” the AS curve, so that shifts of the potential GDP line cause equal shifts of the AS curve: Changes in the nominal wage rate or nominal prices of other resources: An increase in the nominal wage rate or the nominal price of another resource raises firms’ costs and therefore reduces the quantity of output that firms are willing to supply at each price level. The quantity of real GDP supplied at any given price level therefore decreases, and the AS curve shifts to the left. A decrease in the nominal wage rate or the nominal price of another resource reduces firms’ costs and therefore increases the quantity of output that firms are willing to supply at each price level. The quantity of real GDP supplied at any given price level therefore increases, and the AS curve shifts to the right.