APPENDIX C

Aggregate Demand and Aggregate Supply

SUPPLY SHOCKS AND THE DILEMMA BEFORE THE POLICY MAKERS

A supply shock is a disturbance in the economy whose initial impact is to cause a shift of the aggregate supply curve. To analyse the supply shocks, we incorporate not only the labour costs but also the prices of raw materials.

Thus, the price equation can be written as

Analysing the above equation, we observe that

1. The wage rate, W, and thus the price increases with the output level. Therefore, the aggregate supply curve is upward sloping.
2. Given the wage rate, an increase in the price of the materials, P_m, leads to an increase in the price level. This again will lead to an upward shift of the aggregate supply curve.

An Adverse Supply Shock

An adverse supply shock leads to an upward shift of the aggregate supply curve. For example, an increase in the real prices of oil will lead to an upward shift of the aggregate supply curve from AS to AS′ in Figure C.1. The economy’s equilibrium shifts from E to the unemployment equilibrium at E′, increasing the prices and reducing the output level. Also, now at each level of output the production costs are higher.

Over a period of time, due to the existence of unemployment there occurs a decrease in the wages and hence in prices. Slowly, the economy returns to the initial equilibrium at point E, which is the full employment level.

At point E, though the price level is the same as before the shock, the nominal wage and, thus, the real wages are lower as compared to before the shock. Thus, an adverse supply shock reduces the real wage rate.

An adverse supply shock can be dealt with by macroeconomic policy. Accommodating fiscal or monetary policies could shift the aggregate demand curve from AD to AD′. This would shift the economy to E*, which is the full employment level.

Such a policy would certainly decrease the unemployment effects of the supply shocks. But there would be an increase in prices by the full extent of the upward shift in the aggregate supply curve. This happens due to the trade-off between the inflationary impact and the recessionary effects of a supply shock.

Although an adverse supply shock leads to an increase in the price level, a decrease in the GNP and in the real wages, a favourable supply shock would have just the opposite effect—a decrease in the price level, increase in GNP and in the real wages.

Figure C.1 An Adverse Supply Shock

DERIVATION OF THE UPWARD SLOPING AGGREGATE SUPPLY CURVE THROUGH THE PRODUCTION FUNCTION

Step 1: Production Function

The production function relates the output level to employment through the equation

Step 2: Prices and Cost

Step 3: Phillips’ Curve

According to the Phillips’ curve,

The simple Phillips’ curve can be written as

From the above equations, we get

W = W_–1[1 – e(u – u*)]

But                                 

where, N* = Full employment

N = Actual employment

Thus

or

Now

also

Hence,

This can be written as

This is the equation of the aggregate supply curve.