Understanding Aggregate Supply

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1 Understanding Aggregate Supply What do we mean by aggregate supply? Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, AS represents the ability of an economy to deliver goods and services either in the short-term or in the long-term. The nature of this relationship will differ between the long run and the short run 1. Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are held constant. 2. Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average wage rates can change it is a measure of a country s potential output and the concept is linked to the production possibility frontier o In the long run, the AS curve is assumed to be vertical (i.e. it does not change when the general price level changes) o In the short run, the AS curve is assumed to be upward sloping (i.e. it is responsive to a change in aggregate demand reflected in a change in the general price level) This all sounds a bit technical at the moment but as we will see, the easiest way to think about AS is simply to think about the costs of producing different goods and services in the economy. The short run aggregate supply curve

2 General Price Level P3 P2 P1 An expansion of national output A contraction of national output LRAS The short run AS curve is upward sloping because higher prices for goods and services make output more profitable and enable businesses to expand their production by hiring less productive labour and other resources SRAS Y1 Y2 Yfc Real National Income A change in the price level brought about by a shift in AD results in a movement along the short run AS curve. If AD rises, we see an expansion of SRAS; if demand falls we see a contraction of SRAS. The slope of SRAS curve depends on the degree of spare capacity in the economy. 1. Negative output gap: At low levels of real national income where actual GDP < potential GDP, many businesses have spare capacity and can easily expand production without paying their workers overtime or coming up against other supply bottlenecks. The SRAS curve is elastic (in the diagram this might be a movement from Y1 to Y2). 2. Positive output gap: As national output expands and the economy heads towards full capacity, producers may find it harder to raise production. Workers may require payment of overtime and bonuses to work longer hours and increase GDP so SRAS becomes inelastic (e.g. shown from the movement between Y2 and Yfc where Yfc is drawn as a full-capacity level of national output). 3. Diminishing returns: As national output expands, older less productive machinery may be used and less efficient workers hired. 4. Full-capacity output at LRAS. Eventually the economy cannot increase the volume of output further in the short-term. At this point SRAS is perfectly inelastic at Yfc the economy has reached full-capacity (the LRAS curve)

3 General Price Level LRAS P3 P2 Short run aggregate supply is inelastic here a rise in AD will have more of an effect on the general price level than it will on the volume of real national output P1 SRAS Short run aggregate supply is elastic here because there is plenty of spare productive capacity (i.e. the output gap will be negative). A rise in AD will lead easily to an expansion of real national output Y1 Y2 Yfc Real National Income Shifts in short run aggregate supply (SRAS) Shifts in the SRAS curve can be caused by the following factors 1. Changes in unit labour costs: Unit labour costs are wage costs adjusted for the level of productivity. For example a rise in unit labour costs might be brought about by firms paying higher wages or a fall in the level of productivity. If unit wage costs rise, this will feed through into higher prices (this is known as cost-push inflation ) 2. Commodity prices: Changes to raw material costs and other components e.g. the world prices of oil, copper, rubber, iron ore, aluminium and other inputs will affect a firm s costs. 3. Exchange rates: Costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas 4. Government taxation and subsidies: Changes to taxes and subsidies have effects on the costs of producers for example an increase in taxes designed to meet environmental objectives will cause higher costs and an inward shift in the SRAS curve. Conversely a reduction in duty on petrol and diesel would lower costs and cause an outward shift in SRAS. 5. The price of imports: An increased availability of cheaper imports from a lower-cost country has the effect of shifting out SRAS. In a similar fashion, a reduction in a tariff on imports or an increase in the size of an import quota will also boost the supply available at each price level. The exchange rate affects how much a business must pay for imported raw materials and components. Shifts in the short run aggregate supply curve are illustrated in the diagram below

4 General Price Level LRAS SRAS1 SRAS2: A fall in aggregate supply caused by an increase in costs less output can be supplied at each and every price level SRAS2 SRAS1 SRAS3 SRAS1 SRAS3: A rise in aggregate supply caused by a fall in production costs more output can be supplied at each and every price level Yfc Real National Income Long run Aggregate Supply (LRAS) In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology and the availability and quality of factor inputs. A long run production function for a country is often written as follows: o Y* is a measure of potential output o t is the time period Y*t = f (Lt, Kt, Mt) o L represents the quantity and ability of labour input available o Kt represents the available capital stock o Mt represents the availability of natural resources LRAS is determined by the stock of a country s resources and by the productivity of factor inputs (labour, land and capital). Changes in the technology also affect potential real national output. The vertical long-run aggregate supply curve (LRAS) LRAS is assumed to be independent of the price level and is drawn vertical. Neo-classical economists view the LRAS curve as being perfectly inelastic at a level of output where actual GDP has achieved its potential. There will be no unused labour in that all those who are available for employment at the prevailing wage rate will have work in other words, a fullemployment level of national income has been reached.

5 Keynesian economists disagree they believe that an economy can settle at a level of output where there are many people still unemployed because of a lack of AD. They argue for active demand-management using tools such as fiscal and monetary policy. Causes of shifts in the long run aggregate supply curve Any change in the economy that alters the natural rate of growth of output shifts LRAS. Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause the LRAS curve to shift out. This is shown in the diagram below. General Price Level LRAS1 LRAS2 LRAS3 SRAS1 SRAS2 SRAS3 Policies to increase LRAS YFC1 YFC2 YFC3 Real National Income 1. Expanding the labour supply - e.g. by improving incentives. The UK government has also been encouraging an influx of migrants which has added to the supply of labour although it has created concerns about some of the social and political effects. There are some signs that the big influx of migrant workers into the UK is coming to an end. In the long term many countries must find ways of overcoming the effects of an ageing population.

6 2. Increase the productivity of labour e.g. by investment in training of the labour force and improvements in the quality of management of human resources. 3. Improve mobility of labour to reduce certain types of unemployment for example structural unemployment which is caused by occupational immobility of labour. If workers have better skills and increased flexibility, they will find it easier to get work when economic conditions change. Conversely when unemployment remains high, the economy loses out on potential output and there is a waste of scarce economic resources. 4. Expanding the capital stock i.e. increase the level of investment and research and development. 5. Increase business efficiency by promoting greater competition within markets. 6. Stimulate invention and innovation this will hopefully promote lower production costs and also improvements in the dynamic efficiency of markets. Innovation will create new goods and services and encourage investment in new markets. For most advanced nations it is indeed the growth of productivity that is critical to raising the long term growth of real GDP. The following article refers to what is commonly known as the productivity gap between the UK and other leading industrialized economies. UK productivity still trails competitors Gordon Brown's ambition of matching the growth in productivity of the world's big economies appears as elusive as ever after research by the Centre for Economic Performance showed that in terms of output per hour worked, Britain still lags behind Germany by 13 per cent, the US by 18 per cent and France by 20 per cent. "This means that if we could reach French productivity levels, we could award ourselves 20 per cent higher wages or take a day off and still earn the same. Or we could spend the extra resources on schools and hospitals," according to the report s author. The lag in productivity was mainly due to "deficits in innovation, skills and management practices, as well as regulatory constraints in the retail sector," according to the report. The proportion of low-skilled people in the UK was three times higher than in the US and almost double the proportion in Germany and Japan. Aggregate supply shocks Source: Adapted from Financial Times, June 2007 We saw in our chapter on AD that external events can cause shocks to demand for goods and services. Unpredictable shocks are even more frequent when it comes to aggregate supply. Aggregate supply shocks might occur when there is o A sudden rise in oil prices or other essential inputs such as foodstuffs used in foodprocessing industries. Foodstuffs are an example of intermediate products items that are used up in manufacturing goods for consumers to buy o The invention and diffusion of a new production technology o A major change in the movement of migrant workers from one economy to another

7 US dollars per barrel World Crude Oil Price - US Dollars Per Barrel US dollars Source: Reuters EcoWin The obvious recent example is what has happened to the world price of crude oil. Our chart tracks the daily price for West Texas Intermediate, widely regarded as one of the benchmarks for international oil prices. Having been remarkably low in the early years of this decade reaching as low as $17 a barrel in the autumn of 2001 prices spiked to over $140 in the summer of 2008 before falling back even more quickly to a low of $2 at the start of Since then crude oil prices have rebounded to $60-$70. Where will oil prices head next? For businesses that use oil as an essential input, the volatile crude oil price makes planning for the future very difficult. 325 The Economist Commodity Price Index Index of Prices 2000= Industrial Metals Index All Commodities Food Food price inflation Source: Economist Commodity Price Index The years 2007 and witnessed a huge rise in global food prices that gave rise to the term agflation. This was another external shock to economies around the world. One of the

8 major reasons for rising food prices was the rising global price of wheat with wheat prices rising 77% in 2007 alone. Many demand and supply factors were at work: Increased bio-fuel production: Concerns over oil prices, energy security and climate change have prompted governments to take a more proactive stance towards encouraging bio-fuels. This has led to increased demand for bio-fuel raw materials, such as wheat, soy, maize and palm oil, and increased competition for cropland. This led to a loss of resources targeted at the food chain and caused stocks of wheat to fall to a 30 year low. Declining stocks were also affected by the worst drought in Australia in 100 years, which halved the winter crop to 12 million tones in Desertification: Global warming and other environmental shifts are decreasing the quantity of available farmland by over 7 millions hectares a year especially on the African continent. If global warming continues water supplies could be disrupted leading to falling food production. Deforestation, soil erosion and exhaustion are examples of the Tragedy of the Commons. Speculation by investors: Wheat and other prices of commodities soared as they found favour among investors who were struggling with poor returns in other markets. On the demand side, rising incomes in emerging market countries also contributed to higher food prices. Per capita income has been rising in many emerging market countries and so too has demand for foodstuffs that have a strongly positive income elasticity of demand. An obvious example of this is the demand for meat products ñ a land-intensive product. Meat is more land intensive, because you need land for the livestock and crops to feed the livestock. Demographics: Demand has grown because of an expanding population - the global population is expected to rise from 6 billion in 2000 to 9 billion by Currencies: The weakness of the US dollar increased the purchasing power of speculators and other traders who can buy increased volumes of foodstuffs with currencies other than the US dollar driving market demand to even higher levels. Export controls: Some food exporters acted to limit their sales overseas so as to provide sufficient food for their own population. But whilst this helped to keep domestic prices in check it reduced supply on world markets forcing prices higher for food importers. For the UK economy high food price inflation during 2007 and 2008 contributed to a surge in inflation. In the UK it led in part to inflation overshooting the 2% inflation target. Inflation peaked at an annual rate of 5% in the autumn of Inflation also accelerated within the group of countries inside the Euro Area and in many poorer developing nations. Shocks and long run aggregate supply The effects of supply-side shocks are normally to cause a shift in the SRAS curve. But there are also occasions when changes in production technologies or step-changes in the productivity of factors of production that were not expected, feed through into a shift in the long run aggregate supply curve.

9 Natural disasters and political conflicts including civil wars can also have a significant effect on a country s productive potential and therefore affect the LRAS although it is often difficult to measure accurately just how damaging these events have been. Key terms Classical LRAS External shock Innovation Intermediate goods Productive potential Productivity Trend growth Unit wage costs The classical LRAS curve is drawn as vertical because classical economists argue that the productive capacity of the economy is determine by factors other than price and demand. An unpredictable event which creates a disturbance for the economy Changes to products or production processes innovation is very important in delivering improvements in dynamic efficiency Products used up in manufacturing a final good or service for example wheat used in manufacturing cereals or steel used in supplying new cars How many goods and services an economy can supply in the long run A measure of efficiency e.g. measured by output per person employed or output per person-hour The long run average growth rate for an economy mainly determined by changes in the stock of available factor inputs and also improvements in productivity Labour costs per unit of output Suggestions for further reading on short run aggregate supply Dry cleaners hit by rising costs (BBC news, June 2008) Fuel costs push up inflation (BBC news, June 2008) High oil prices hit global economies (BBC news, June 2008) The end of cheap clothes is near (BBC news, April 2008) UK manufacturers raising prices (BBC news, June 2008) Crude oil s rollercoaster prices (BBC news, July 2009) Suggestions for further reading on long run aggregate supply Contrasting views on EU migration (BBC news, April 2008) Innovation in the National Health Service (BBC news, July 2008) Inward investment success for the UK (BBC news, July 2008) UK plans big wind power expansion (BBC news, June 2008) US workers top productivity table (BBC news, October 2007)

10 Building BRICS of growth (The Economist, June 2008) Infrastructure s value to economic growth (BBC news, March 2009) Public sector productivity falls (BBC news, June 2009) Japan s machinery orders plunge (BBC news, January 2009)

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