National Income and Price Determination

1. National Income and Price Determination AP Economics Mr. Bordelon

2. Aggregate Supply • Economists model economy-wide consumption of g/s with AD, which is downward sloping. The downward slope shows consumption of g/s (real GDP) declines when APL increases. • Aggregate Supply (AS) shows the relationship between economy-wide production and APL. • In the short run, there is a positive slope to the short-run aggregate supply curve (SRAS). • In the long run, the long-run aggregate supply (LRAS) is vertical at the level of potential GDP.

3. Short-Run Aggregate Supply This is the SRAS curve. It is your friend. In the SR, there is a positive relationship between APL and aggregate QS, other things equal. Remember, the goal of producers is to earn profit. Each producer will produce according to whether a unit of output is profitable or not.

4. Short-Run Aggregate Supply Profit = Price – Production Cost Suppose that the price of a unit of output increased, but production cost of that unit stayed the same. Profit on that unit will rise, and so it will be produced. Suppose the price of output increased by 5%, while the production cost increased by 1%. Profit on that unit will also rise, so it will be produced.

5. Short-Run Aggregate Supply If the price of a unit of output is rising faster than the cost of producing that unit of output, that unit of output will be produced. This is what economists believe happens in the short run, and gives the SRAS an upward slope. Why?

6. Short-Run Aggregate Supply Some input prices are “sticky,” which means that they don’t increase or decrease very quickly in response to a change in demand for them. Part of this is an issue of elasticity of supply. However, the real culprit is the difference in fixed and variable costs in the long term and short term. Labor is the most common example used on the AP exam on this point.

7. SRAS—Labor • Strong economy • Demand for products is strong and producers are selling their output increasingly, with rising output prices, and profit per unit of output is increasing. • Eventually producers need to hire more workers, and the demand curve for labor shifts to the right. • Employers are reluctant to raise nominal wages and some employees have already agreed to be paid a lower wage so those wages are fixed for the time being. • Eventually the competition for good workers gets so fierce that nominal wages begin to rise. • NOT REAL. We’re talking the actual numerical value of wages. • Conclusion: Price of output increased quickly with stronger demand, but the price of labor (nominal wage) increased much more slowly.

8. SRAS—Labor • Weak economy • Demand for products is weak, the economy is in recession. Producers are selling fewer units of output, with falling output prices, and profit per unit of output is decreasing. • Eventually producers need to reduce employment of workers, and so the demand curve for labor shifts to the left. • Employers are reluctant to immediately lower nominal wages because they will lose employees. Some employees have already signed contracts at a higher wage so those wages are fixed for the time being. • Eventually the labor market gets so weak, and unemployment is so high, that nominal wages begin to fall. • Conclusion: The price of output decreased quickly with weaker demand, but the price of labor (nominal wage) decreased much more slowly.

9. Shifts of SRAS • An increase, shift to the right, in SRAS means producers are willing to produce more aggregate output at any price level. • A decrease, shift to the left, in SRAS means producers are less willing to produce aggregate output at any price level. • Changes in Commodity Prices • Changes in Nominal Wages • Changes in Productivity

10. Shifts of SRAS • Changes in Commodity Prices • Commodity. Standardized input brought and sold in bulk quantities. Oil, copper, steal. • Commodities are production inputs for many final products. • Higher commodity prices make it more costly for firms economy-wide to produce. SRAS shifts left. • Lower commodity prices make it less costly for firms economy-wide to produce. SRAS shifts right.

11. Shifts of SRAS • Changes in Nominal Wages • Think labor here. The current price of labor is the nominal wage. • If nominal wages increase, SRAS shifts left. • If nominal wages decrease, SRAS shifts right.

12. Shifts of SRAS • Changes in Productivity • Example. Workers at a factory are provided with better tools so that they can increase output with the same amount of effort (look for technology). • SRAS shifts right. • Example. Workers find their factories destroyed so that their output drops to nothing (look for disasters, wars). • SRAS shifts left.

13. Shifts of SRAS

14. Shifts of SRAS

15. Long-Run Aggregate Supply • SRAS slopes upward because nominal wages are sticky. But what if they were not? What if there was enough time for wages to adjust? (Think short term going to long term). • If the price of output increased by 5% and nominal wages also increased by 5%, there would be no profit incentive to increase output. All that would change is an increase in APL.

16. Long-Run Aggregate Supply Drawing this out, we’d end up with a vertical curve, where APL increases, but no increase in real GDP. LRAS intersects the x-axis at YP, the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. Given enough time,the economy will adjust back to this level of output.

17. Short-Run to Long-Run • The economy is trying to reach long-run equilibrium (LRE), meaning that it fluctuates around the level of YP. Sometimes the economy is weak, and real GDP lies below YP. Sometimes the economy is strong and real GDP lies above YP. • In the AD/AS model, the economy is always operating along the SRAS curve, but this only coincides with LRE sometimes. • The AD/AS model predicts that in the long-run, the economy will adjust to where SRAS intersects LRAS at YP, at LRE.

18. Long-Run Aggregate Supply Drawing this out, we’d end up with a vertical curve, where APL increases, but no increase in real GDP. LRAS intersects the x-axis at YP, the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. Given enough time,the economy will adjust back to this level of output.

19. Long-Run Aggregate Supply

20. Long-Run Aggregate Supply The economy is weak and in a recession. Here, current real GDP Y1 < YP. Weak labor market has falling demand for labor. There are many unemployed workers. Employers find that they can get workers to accept lower wages. Eventually nominal wages decrease and SRAS shifts right until current output equals YP.

21. Long-Run Aggregate Supply The economy is booming, jack. Here, current real GDPY2 > YP. Strong labor market has rising demand for labor. Very few workers that are unemployed. Employers are trying to find employees, which are scarce. Eventually nominal wages rise and SRAS shifts left until output equals YP.

22. Question 1 • Determine the effect on SRAS of each of the following events. Explain whether it represents a movement along the SRAS curve or a shift of the curve. • Hackers from a foreign country disable most corporate computing systems. This disruption continues off and on for several months. • The price of grain, a key commodity, drastically increases as the nation switches to more biofuels as sources of energy. • The First Lady’s goal of doubling the fraction of high school seniors that graduate from college is successful. • Due to a weak economy, the consumer price index falls for several consecutive months. • Labor unions are successful in organizing members throughout the economy and they negotiate higher wages and benefits.