This preview shows pages 1–3. Sign up to view the full content.
This preview has intentionally blurred sections. Sign up to view the full version.View Full Document
Unformatted text preview: Chapter 7: All Markets Together: The AS-AD Model Aggregate Supply Aggregate supply shows the total amount of final goods and services that are willing and able to be produced by the economy at a given price. Supplying goods and services require the production and distribution of them. In the production process, labors have to be hired. As a result, to discuss aggregate supply, the labor market and price setting process have to be considered. In the previous chapter the wage and price setting relations are described as: W = P e F(u, z) P = (1 + ) W Putting together these 2 equations P = (1 + ) P e F(u, z) or P = P e (1 + ) F(u, z) It suggests that actual price level depends on expected price level, unemployment rate, markup and other factors, such as unemployment benefits that can affect wage level. Unemployment rate u, can be measured as: L N L N L L U u- =- = = 1 Given the production Y = AN and assuming A = 1, then Y = N (it takes one worker to produce one output), then: L Y u- = 1 it shows that given a fixed labor force, the higher the output Y, the lower the unemployment rate. Replace u in the price equation: ] , 1 [ ) 1 ( z L Y F P P e- + = The equation suggests that the actual price level depends on the expected price, the level of output, the markup and other factors that affect wages. This is also the aggregate supply function since it considers the supply side factors of wage and price setting, as well as showing the relation between output and price. Properties of the Aggregate Supply Function An increase in output leads to an increase in the price level since: 1. An increase in output leads to an increase in employment. 2. The increase in employment leads to a decrease in unemployment and, therefore, to a decrease in the unemployment rate. 3. The lower unemployment rate leads to an increase in nominal wage. 1 4. The increase in the nominal wage leads to an increase in the price set by firms and, therefore, to an increase in the price level. An increase in the expected price level leads, one for one, to an increase in the actual price level as: 1. If wage setters expect the price level to be higher, they set a higher nominal wage (since workers may ask for it). Or when workers expect a higher price, they ask for higher nominal wages. 2. The increase in nominal wage leads to an increase in costs, which leads to an increase in the prices set by forms and a higher price level. The aggregate supply curve is upward sloping, indicating that an increase in output Y leads to an increase in price level P. When the output level Y equals to the natural output level Y n , the price level P turns out to be the expected price level P e . This conclusion is made based on the discussion in the previous chapter in which P = P e , then an equilibrium level of unemployment is reached. This level of unemployment is also called natural rate of unemployment u n (full employment). The output level associated with this level of unemployment is known as the natural rate of output Y...
View Full Document
This note was uploaded on 04/05/2009 for the course ECIF ECIF200 taught by Professor Henry during the Spring '09 term at University of Manchester.
- Spring '09