To complete our analysis, we need to derive an aggregate supply curve, a curve that

shows the relationship between the quantity of output supplied and the inflation rate. In
the typical supply and demand analysis, we have only one supply curve, but because
prices and wages take time to adjust to their long-run levels, the aggregate supply curve
differs in the short and long runs. First we examine the long-run aggregate supply curve;
then we derive the short-run aggregate supply curve. Finally, we look at how both of
these curves shift over time and at how the economy moves from the short run to the
long run.
Long-run aggregate supply Curve
The amount of output that can be produced in the economy in the long run is
determined by the amount of capital in the economy, the amount of labor supplied
at full employment, and the available technology. As discussed in Chapter 16, some
unemployment cannot be helped because it is either frictional or structural. Thus,
at full employment, unemployment is not at zero but is rather at a level above
zero at which the demand for labor equals the supply of labor. This natural rate
of unemployment is the rate to which the economy gravitates in the long run. Many
economists believe that the natural rate of unemployment is currently between
5% and 6%.
The level of aggregate output produced at the natural rate of unemployment is
called the natural rate of output but is more often referred to as potential output: It
is the level at which the economy settles in the long run for any inflation rate. Suppose
potential output is at $10 trillion. The long-run aggregate supply curve (LRAS) is then
vertical at the $10 trillion of potential output, denoted by Yp as drawn in Figure 3.

Short-run aggregate supply Curve

The short-run aggregate supply curve is based on the idea that three factors drive
inflation: (1) expectations of inflation, (2) the output gap, and (3) inflation (supply)
shocks.
expected inflation, 𝛑e Workers and firms care about wages in real terms—that
is, in terms of the goods and services that wages can buy. When workers expect a
positive inflation rate, they will adjust nominal wages upward one-to-one with the
expected inflation rate, so that the real wage rate does not decrease. Thus, holding
everything else constant, wage inflation will rise one-to-one with rises in expected
inflation. Because wages are the most important cost of producing goods and services,
overall inflation will also rise on a one-to-one basis with increases in expected
inflation.

Output gap The output gap is defined as the percentage difference between aggregate
output and potential output, Y – YP. When output exceeds its potential level and the
output gap is high, there is very little slack in the economy. Workers will demand higher
wages, and firms will take the opportunity to raise prices. The end result will be higher
inflation. Conversely, when the output gap is negative, there will be a lot of slack in the
economy. Thus workers will accept smaller increases in wages, and firms will need to
lower prices to sell their goods, resulting in lower inflation.

Inflation (supply) shocks Supply shocks occur when there are shocks to the
supply of goods and services produced in the economy that translate into Inflation
shocks, that is, shifts in inflation that are independent of the amount of slack in the
economy or expected inflation. For example, when the supply of oil is restricted, as has
occurred several times when Middle East countries were at war, the resulting rise in the
price of oil leads firms to raise prices more to reflect the increased costs of production,
thus driving up inflation. Energy inflation shocks can also occur when demand increases
for example, increased demand from developing countries like China such as occurred
in 2007–2008 again driving up inflation. Inflation shocks can also come from rises
in import prices or from cost-push shocks in which workers push for wages that are
higher than productivity gains, thereby driving up costs and inflation.

Short-run aggregate supply Curve Putting all of our analysis together, we can
write the following equation for the short-run aggregate supply curve:
RUMUS DIBUKU JANGAN LUPA DITULIS
The short-run aggregate supply curve given in Equation 2 tells us that inflation is driven
by three factors: (1) expectations of inflation, (2) output gaps, and (3) inflation shocks.
Why the short-run aggregate supply Curve is upward-sloping To see why the short-run
aggregate supply curve, AS, in Figure 3 is upward-sloping, let’s assume that expected
inflation is at 2% and that there are no inflation shocks. When actual output equals
potential output at $10 trillion, the output gap, Y - YP
, is zero, and so Equation 2 indicates
that the inflation rate will equal the expected inflation rate of 2%. The combination
of $10 trillion of aggregate output and a 2% inflation rate is shown by point 1 on the AS
curve. (Note that the short-run aggregate supply curve in Figure 3 is marked as AS (̀
e = 2% )to indicate it is drawn assuming e
̀ = 2%.)
Now suppose that aggregate output rises to $11 trillion. Because there is a
positive output gap (Y = $11 trillion 7 YP = $10 trillion), Equation 2 indicates that
inflation will rise above 2%, say to 3.5%, marked as point 2. The curve connecting
points 1 and 2 is the short-run aggregate supply curve, AS, and it is upward-sloping.
When Y rises relative to YP and Y 7 YP, the labor market is tighter and firms raise their
prices at a more rapid rate, causing the inflation rate to rise. Thus the AS curve is
upward-sloping.

Price stickiness and the short-run aggregate supply Curve

If wages and prices are sticky, inflation adjusts slowly over time. The more flexible
wages and prices are, the more rapidly they, and inflation, respond to deviations of
output from potential output; that is, more flexible wages and prices imply that the
absolute value of ̀ is higher, which in turn implies that the short-run aggregate supply
curve is steeper. If wages and prices are completely flexible, then ̀ becomes so large
that the short-run aggregate supply curve becomes vertical and is identical to the long
run aggregate supply curve.