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The logic is exactly the same.
Although producers use many inputs other than labor, the one that has attracted the
most attention in recent decades is energy. Increases in the prices of imported energy, such
as those that took place over most of the period from 2002 until this book went to press,
push the aggregate supply curve inward”as shown in Figure 2. By the same token, de-
creases in the price of imported oil, such as the ones we enjoyed briefly in the second half
of 2006, shift the aggregate supply curve in the opposite direction”outward.

Technology and Productivity Another factor that can shift the aggregate supply curve
Productivity is the amount
of output produced by a is the state of technology. The idea that technological progress increases the productivity of
unit of input. labor is familiar from earlier chapters. Holding wages constant, any increase of productivity
will decrease business costs, improve profitability, and encourage more production.
Once again, our gadget example will help us understand how this process works. Sup-
pose the price of a gadget stays at $9 and the hourly wage rate stays at $8, but gadget
workers become more productive. Specifically, suppose the labor input required to manu-
facture a gadget decreases from one hour (which costs $8) to three-quarters of an hour
(which costs just $6). Then unit profit rises from $1 to

$9 2 (3„4) $8 5 $9 2 $6 5 $3
The lure of higher profits should induce gadget manufacturers to increase output”
which is, of course, why companies constantly strive to raise their productivity. In brief,
we have concluded that

Improvements in productivity shift the aggregate supply curve outward.
We can therefore interpret Figure 2 as illustrating the effect of a decline in productivity. As
we mentioned in Chapter 7, a slowdown in productivity growth was a persistent problem
for the United States for more than two decades starting in 1973.

Available Supplies of Labor and Capital The last determinants of the position
of the aggregate supply curve are the ones we studied in Chapter 7: The bigger the

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Chapter 10 203
Bringing in the Supply Side: Unemployment and Inflation?

economy”as measured by its available supplies of labor and capital”the more it is capa-
ble of producing. Thus:
As the labor force grows or improves in quality, and as investment increases the capital
stock, the aggregate supply curve shifts outward to the right, meaning that more output
can be produced at any given price level.
So, for example, the great investment boom of the late 1990s, by boosting the supply of
capital, left the U.S. economy with a greater capacity to produce goods and services”that
is, it shifted the aggregate supply curve outward.
These factors, then, are the major “other things” that we hold constant when drawing
an aggregate supply curve: nominal wage rates, prices of other inputs (such as energy),
technology, labor force, and capital stock. A change in the price level moves the economy
along a given supply curve, but a change in any of these determinants of aggregate quantity
supplied shifts the entire supply schedule.

Chapter 9 taught us that the price level is a crucial deter-
minant of whether equilibrium GDP falls below full
employment (a “recessionary gap”), precisely at full em- S
ployment, or above full employment (an “inflationary
Price Level (P )

gap”). We can now analyze which type of gap, if any, will 120
occur in any particular case by combining the aggregate 110 E
supply analysis we just completed with the aggregate de-
mand analysis from the last chapter. 80
Figure 3 displays the simple mechanics. In the figure, the
aggregate demand curve DD and the aggregate supply
curve SS intersect at point E, where real GDP (Y) is $6,000
billion and the price level (P) is 100. As can be seen in the
5,200 5,600 6,000 6,400 6,800
graph, at any higher price level, such as 120, aggregate Real GDP (Y )
quantity supplied would exceed aggregate quantity de-
manded. In such a case, there would be a glut of goods on NOTE: Amounts are in billions of dollars per year.
F I GU R E 3
the market as firms found themselves unable to sell all their
Equilibrium of Real
output. As inventories piled up, firms would compete more vigorously for the available
GDP and the
customers, thereby forcing prices down. Both the price level and production would fall.
Price Level
At any price level lower than 100, such as 80,
quantity demanded would exceed quantity
supplied. There would be a shortage of goods
Determination of the Equilibrium Price Level
on the market. With inventories disappearing
and customers knocking on their doors, firms (1) (2) (3) (4) (5)
would be encouraged to raise prices. The price Aggregate Aggregate Balance of
level would rise, and so would output. Only Quantity Quantity Supply and Prices
Price Level Demanded Supplied Demand will be:
when the price level is 100 are the quantities of
real GDP demanded and supplied equal. 80 $6,400 $5,600 Demand Rising
Therefore, only the combination of P 5 100 and exceeds supply
90 6,200 5,800 Demand Rising
Y 5 $6,000 is an equilibrium.
exceeds supply
Table 1 illustrates this conclusion by using a
100 6,000 6,000 Demand Unchanged
tabular analysis similar to the one in the previ- equals supply
ous chapter. Columns (1) and (2) constitute an 110 5,800 6,200 Supply Falling
aggregate demand schedule corresponding to exceeds demand
120 5,600 6,400 Supply Falling
curve DD in Figure 3. Columns (1) and (3) con-
exceeds demand
stitute an aggregate supply schedule corre-
sponding to aggregate supply curve SS. NOTE: Quantities are in billions of dollars.

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Part 2
204 The Macroeconomy: Aggregate Supply and Demand

The table clearly shows that equilibrium occurs only at P 5 100. At any other price
level, aggregate quantities supplied and demanded would be unequal, with consequent
upward or downward pressure on prices. For example, at a price level of 90, customers
demand $6,200 billion worth of goods and services, but firms wish to provide only
$5,800 billion. In this case, the price level is too low and will be forced upward. Con-
versely, at a price level of 110, quantity supplied ($6,200 billion) exceeds quantity
demanded ($5,800 billion), implying that the price level must fall.

To illustrate the importance of the slope of the aggregate supply curve, we return to a
question we posed in the last chapter: What happens to equilibrium GDP if the aggregate
demand curve shifts outward? We saw in Chapter 9 that such changes have a multiplier
effect, and we noted that the actual numerical value of the multiplier is considerably
smaller than suggested by the oversimplified multiplier formula. One of the reasons, vari-
able imports, emerged in an appendix to that chapter. We are now in a position to under-
stand a second reason:

Inflation reduces the size of the multiplier.

The basic idea is simple. In Chapter 9, we described a multiplier process in which one
person™s spending becomes another person™s income, which leads to further spending
by the second person, and so on. But this story was confined to the demand side of the
economy; it ignored what is likely to be happening on the supply side. The question is:
As the multiplier process unfolds, will firms meet the additional demand without rais-
ing prices?
If the aggregate supply curve slopes upward, the answer is no. More goods will be pro-
vided only at higher prices. Thus, as the multiplier chain progresses, pulling income and
employment up, prices will rise, too. This development, as we know from earlier chap-
ters, will reduce net exports and dampen consumer spending because rising prices erode
the purchasing power of consumers™ wealth. As a consequence, the multiplier chain will
not proceed as far as it would have in the absence of inflation.
How much inflation results from a given rise in aggregate demand? How much is the
multiplier chain muted by inflation? The answers to these questions depend on the slope
of the economy™s aggregate supply curve.
For a concrete example, let us return to the $200 billion increase in investment spen-
ding used in Chapter 9. There we found (see especially Figure 10 on page 186) that
$200 billion in additional investment spending would eventually lead to $800 billion in
additional spending if the price level did not rise”that is, it tacitly assumed that the aggregate
supply curve was horizontal. But that is not so. The slope of the aggregate supply curve tells
us how any expansion of aggregate demand gets apportioned between higher output and
higher prices.
In our example, Figure 4 shows the $800-billion rightward shift of the aggregate de-
mand curve, from D0D0 to D1D1, that we derived from the oversimplified multiplier for-
mula in Chapter 9. We see that, as the economy™s equilibrium moves from point E0 to
point E1, real GDP does not rise by $800 billion. Instead, prices rise, cancelling out part of
the increase in quantity demanded. As a result, output rises from $6,000 billion to $6,400
billion”an increase of only $400 billion. Thus, in the example, inflation reduces the multi-
plier from $800/$200 5 4 to $400/$200 5 2. In general:
As long as the aggregate supply curve slopes upward, any increase in aggregate demand
will push up the price level. Higher prices, in turn, will drain off some of the higher real
demand by eroding the purchasing power of consumer wealth and by reducing net ex-
ports. Thus, inflation reduces the value of the multiplier below what is suggested by the
oversimplified formula.

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Chapter 10 205
Bringing in the Supply Side: Unemployment and Inflation?

Notice also that the price level in this example has been F I GU R E 4
pushed up (from 100 to 120, or by 20 percent) by the rise Inflation and the Multiplier
in investment demand. This, too, is a general result:
As long as the aggregate supply curve slopes upward,
any outward shift of the aggregate demand curve will
increase the price level.
The economic behavior behind these results is certainly
not surprising. Firms faced with large increases in quan- S

Price Level (P )
tity demanded at their original prices respond to these $800
changed circumstances in two natural ways: They raise billion
production (so that real GDP rises), and they raise prices 110 E0 A
(so the price level rises). But this rise in the price level, in 100
turn, reduces the purchasing power of the bank accounts D1
and bonds held by consumers, and they, too, react in the
natural way: They reduce their spending. Such a reaction D0
amounts to a movement along aggregate demand curve
D1D1 in Figure 4 from point A to point E1.
6,000 6,400 6,800
Figure 4 also shows us exactly where the oversimpli-
fied multiplier formula goes wrong. By ignoring the ef- Real GDP (Y )
fects of the higher price level, the oversimplified formula
erroneously pretends that the economy moves horizon- NOTE: Amounts are in billions of dollars per year.
tally from point E0 to point A”which it will not do unless
the aggregate supply curve is horizontal. As the diagram clearly shows, output actually
rises by less, which is one reason why the oversimplified formula exaggerates the size of
the multiplier.

With this understood, let us now reconsider the question we have been deferring: Will
equilibrium occur at, below, or beyond potential GDP?
We could not answer this question in the previous chapter because we had no way to
determine the equilibrium price level, and therefore no way to tell which type of gap, if
any, would arise. The aggregate supply-and-demand analysis presented in this chapter
now gives us what we need. But we find that our answer is still the same: Anything can
The reason is that Figure 3 tells us nothing about where potential GDP falls. The factors
determining the economy™s capacity to produce were discussed extensively in Chapter 7.
But that analysis could leave potential GDP above the $6,000 billion equilibrium level or
below it. Depending on the locations of the aggregate demand and aggregate supply
curves, then, we can reach equilibrium beyond potential GDP (an inflationary gap), at
potential GDP, or below potential GDP (a recessionary gap). All three possibilities are
illustrated in Figure 5 on the next page.
The three upper panels duplicate diagrams that we encountered in Chapter 9.2 Start
with the upper-middle panel, in which the expenditure schedule C 1 I1 1 G 1 (X 2 IM)
crosses the 45o line exactly at potential GDP”which we take to be $7,000 billion in the
example. Equilibrium is at point E, with neither a recessionary nor an inflationary gap. Now
suppose that total expenditures either fall to C 1 I0 1 G 1 (X 2 IM) (producing the upper-
left diagram) or rise to C 1 I2 1 G 1 (X 2 IM) (producing the upper-right diagram). As we
read across the page from left to right, we see equilibrium occurring with a recessionary
gap, exactly at full employment, or with an inflationary gap”depending on the position

Recall that each income-expenditure diagram considers only the demand side of the economy by treating the

price level as fixed.


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