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.

Serial Inflation or the cost of inflation

Everyone knows that inflation is a bad thing; deflation may be worse but neither is desirable. What central banks shoot for is price stability, so that businesses and consumers can plan accordingly to maximize their utility. However, it was Mark Twain that said “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”

What do I mean? Well, inflation may be the cruelest tax but the drop in purchasing power may not be all that it is cracked up to be. See that is why people dislike inflation. It is ingrained in their head that if the dollar loses value, that their dollar purchases less goods and services. This is a bad thing, no? Here is their evidence.


Pretty rough. Since the advent of the Federal Reserve, the private bank has eroded each Americans wealth by 93.4%. The thinking described must advances a theory that American standard of living has dropped in step with the fall of the dollar. However, I don't remember seeing any HDTV, MRI machines, air conditioners during the 1913 period in my history textbooks. Not seeing these items is not direct proof per se, but until I see one I will assume they weren't prevalent, at least to the degree that they are today.

Another way of saying this would be that, the dollar is used to purchase goods and services. People provide goods and services at their job. Thus, the price level rising (the dollar's value declining) tends to net out because the inflation that drives down the purchasing power is also being inflated in the person's offered labor.

One last way of putting this is by numerical example. The CPI index states that inflation rose by 3% last year, (made up.) Last year, you received a 3% raise, so net net you are even. You have not lost purchasing power; your yearly bonus helps safeguard your standard of living.

**Addendum**
I re-read my post and it makes sense but I wanted to add flavor and nuance to the argument. So I needed a multi-year argument to further convince you. So I went and grabbed the Census department's median income in current (nominal) dollars and in real terms as well. I also added the BLS CPI price levels matching set of data from 1975 to 2008 year end.

So first I took a compound annual growth rate for both series, to bring about a unified number so that an apple to apple comparison could be made. To do this I took the last year of my data for each set and divided it by the initial year. I then raised it to 1 over the number of years difference, which is 1/33 years. I then subtracted by one to end up with a annual growth rate percentage. For median income it was 4.49% and for the CPI price level data it was 4.39%. What these two figures mean is that over the period between 1975 and 2008 on average, that is linearly, median income outpaced inflation (what the CPI price levels measure.) You may then draw the conclusion that standards of living have risen because income has outpaced inflation.


If you still do not believe me the Census bureau in the same data set provides the median income in real terms. From 1975 to 2008 the "real" amount of annual wealth accumulation has risen from $42,936 to $50,303. Meaning most households can purchase more than they could back in 1975, thus their standard of living has increased. (Note: I use median income because average income can be skewed by the Bill Gates-s of the world. Ever hear the quip, when Bill Gates walks into the room on average we are all billionaires?)

Though the fallacy should relieve you, inflation still does have an effect and can lower your standard of living in other ways. One is called shoe leather cost. It is the affect, where you have to change your paycheck into a store of value. That is instead of placing your paycheck into a demand deposit account, you because of your knowledge of inflation instead place your funds into a money market account. Now though you have to transfer funds back to the demand deposit account when you go to the restaurant or take the children to the amusement park. This isn't bad in the United States. However, imagine you were in Zimbabwe last year where inflation ran at 36,000%. The cost of your meal would be more the longer you ate, so I am positive that the Zimbabwe equivalent of McDonald's did brisk business last year.

Another is an effect called the menu effect, after restaurant menus. It means that businesses set prices and are reluctant to change them. Again our low inflation environment makes the effect a bit myopic but if inflation ran at a higher rate, businesses would be forced to change their "menu" more often so as to not be burned by their margin contraction as their inputs cost more while their own prices stayed the same.

Finally, there is one last way in which inflation can hurt you and it is in investing. Hypothetically, you buy a share of GM in 1971 for 100 dollars. Now almost 40 years later, after counting for splits the stock is worth 300 dollars. You would be assessed a capital gain tax on 200 dollars at a 20% rate. Here is where inflation stings. Look at the chart above. The dollar was worth 24 cents. Now it is worth 4.6 cents. It has lost almost 6 times its value. Meaning your 100 1971 dollars could buy almost 600 dollars today. So in fact your capital gain is not real, you have lost 50% of your money over the time period. Yet you are still taxed 40 dollars because taxes are assessed nominally and not indexed. Ouch!