Monday, October 26, 2009

Aggreagte Supply

Back on the 14th I began working on short run models of the economy. The first post focused on Aggregate Demand, now I will continue on to aggregate supply and finally I will work with them to create an equilibrium.

Like the AD line, the AS line tells you how much good/services an economy will provide across the pricing continuum. Most economist believe that in the long run the AS curve is vertical in the long run. This is because it is based upon the natural resources of a country, its capital, its labor and its technology. It relies on these inputs to create output goods & services. Thus, pricing will not really have an effect "in the long run" on what an economy produces. This is because prices are a nominal feature of the economy, if you took two countries with identical economies except A had 3x as much money in circulation as B, then the prices of goods in country A would be three times more expensive but both economies would produce the same amount of output.
However, in the short run the veil of prices may allow for economic fluctuations, which is what this post focuses on.

Here is the chart of the economy in the long run. If the pricing level rises or falls it should not effect the long run output of the economy. However, we might ask what can shift the AS left or right?

Above we mentioned natural resources of a country, its capital, its labor and its technology as factors that can affect the LR AS curve, so we should look at these variables in turn.
  • Natural Resources -not as big an effect on the US at this point, but it is very important for say Mongolia. Basically, as new mineral deposits are found this will shift the curve outward; dwindling reserves, if that happened in Saudi Arabia, would have the opposite effect of shifting AS down.
  • Capital - factories, machines, houses, worker knowledge. Any effect on these variables will affect the LR AS, and it is a perfect correlation. A storm that permanently disables a factory would shift the LR AS curve down, left.
  • Labor - Again a perfect correlation, additions add to the AS curve and subtractions remove from it. If a plague attacks the citizens of France, the loss of workers would shift the AS curve downward [left] as France would no longer be able to produce as much as it had in the past.
  • Technology - additions to technological knowledge will make processes more efficient. This is what has enabled crop yields to double from 1950 to 1980 and triple by 2008. The addition of technology adds to the LR AS curve.

Next, we can see how an economy shifts around in the long run.

As the economy adds technology, workers and capital its LR supply curve shifts outward. Holding everything else equal (ceteris paribus) this will cause prices to decline. [Right chart] However, the Federal Reserve mandate is to maintain price stability, so it will be increasing the monetary supply so that aggregate demand increases in accord with shifts in the AS curve. So in the second graph, we show the secondary effect in red arrows as the Fed adds money to keep prices stable at P1* and P3*.

We can also more importantly view the AS curve in the short term, which is why we have undertaken this post. Economists believe that the supply curve slopes upward (from bottom right to upper left) so that the quantity of goods/services supplied increases with increases in the price level. The theory underpinning this idea, at least the one I subscribe to, is called sticky-wage theory. The idea, is that wages do not adjust to changing economic environments as quickly as the price of other goods/services. One aspect may be contracts, like union contracts, and another might be that firms rarely drop wages and instead tend to lay off workers.

So you can imagine a company that pays it's worker 20 cents for each good it makes, which costs 1 dollar total including the wage. In the upcoming year the price level falls so that the firm receives on average 95 cents. It cannot asks its workers to take the 5% cut in their wages, so it must suffer. Now the company is less profitable, so it may lay off workers and cut capacity. Over time wages will match the new price level but in the meanwhile employment and production remain below its optimal level. Sound familiar workforce 2008?

Thus, you can see since price level has decreased the factory will provide less goods. This of course works in the reverse, if the price level is higher the firm will higher more workers and create more goods.

There are some other theories as well including menu costs (this posits that it takes time for suppliers of goods/services to communicate changes of prices to their customers, like changing the menu board at a fast food restaurant) and mis-perceptions theory (this posits something like gasoline prices at the pump in 2008, when you see those numbers rolling like a slot machine once a week, you think that all prices are rising.) Thus, they conclude that they need to ask more for wages or increase the amount of goods they supply at their job. Both these theories explore why the curve slopes upward.

Now we can ask why the short run AS curve might shift. All three theories should give you some idea that the key in the short run is expectations. If the price level is different than what is expected than the supply curve can either shift outward (gasoline prices rising) or inward based upon what the consumers think that price level will be.

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