| | | | | | 1. At low levels of output, with excess capacity, firms are able to increase output without requiring price increases. Hoarded labor and idle machinery can be used to increase output without any increase in per-unit costs. In this zone the aggregate supply curve is flat, corresponding to the flowchart explanation given in figure 4.1. | | | | | | | | | 2. At intermediate levels of output, firms find that to produce more output they must pay current workers overtime, hire inexperienced, less-productive workers, pay higher wages to attract additional workers, and use older, less efficient machinery. Consequently, they increase output only if prices increase to cover higher per-unit costs. The aggregate supply curve becomes upward sloping. | | | | | | | | | 3. At some very high level of output, firms can no longer increase output because they have reached the physical limit of their capacity to produce output. The aggregate supply curve becomes vertical. | | | | | | | | | Anything that increases firms' costs shifts the AS curve in the upward direction. This result occurs because firms will supply the same output only if they are compensated for their higher costs by a higher price. A wage increase is an example of an increase in an input cost shifting the AS curve upward. Oil price increases engineered by OPEC in the 1970s constitute another prominent example. Readers are reminded that a change in the price level moves the economy along the AS curve; changes in all other variables cause shifts. | | | | | | | | | 5.2
The Aggregate Demand Curve | | | | | | | | | To be useful, a supply curve must be paired with a demand curve. In this case an aggregate demand curve is developed by specifying that when the overall price level decreases, real demand for goods and services increases. The negative relationship between the overall price level and aggregate demand for goods and services comes about for three reasons: | | | | | | | | | 1. The wealth effect. Some of people's wealth is held in the form of financial assets such as cash or bonds. A fall in prices of goods and services means that the purchasing power of these financial assets increases. This rise in people's wealth may cause them to increase their consumption spending. Suppose, for example, you own a bond worth $10,000. If the price level fell so dramatically that a sports car originally costing $50,000 now only cost $5,000, wouldn't you feel wealthy enough to buy such a car? In general, a fall in the price level causes the wealth of those who have loaned money to rise, inducing them to increase their consumption spending. Conversely, borrowers experience a decrease in their wealth and, feeling poorer, decrease their consumption. The decrease is quite small, however, because the dominant borrower, the government, is assumed not to change its spending. Consequently, the lenders' reaction generates a net wealth effect on consumption. | | | | |
