3.3 - Aggregate Supply

The definition of aggregate supply

Aggregate supply represents the total amount of goods and services that domestic firms plan to produce and offer at various average price levels over a specific period.

Key characteristics of aggregate supply:

• Aggregate supply is not the same as real gross domestic product (GDP).
• Instead, aggregate supply illustrates the planned output that firms aim to supply at different price levels.
• The shape of the aggregate supply curve varies depending on the assumptions made by different economic schools of thought, such as Monetarists/New Classical economists and Keynesians.

Monetarist/New Classical short-run aggregate supply

Monetarists and New Classical economists separate aggregate supply into short-run and long-run forms. Short-run aggregate supply (SRAS) applies to periods where certain costs, like wages, cannot adjust quickly.

Features of short-run aggregate supply

The short run is a timeframe when money wages remain fixed and cannot respond to shifts in the average price level. Money wages are the amount shown on a payslip. Real wages, which reflect purchasing power, are calculated using the formula:

$$W_r=\frac{W_m}{\text{APL}}$$

Where:

• $W_r$ = Real wage
• $W_m$ = Money wage
• APL = Average price level

Impact of price level changes:

• If the average price level rises while money wages stay the same, real wages fall, encouraging firms to increase output.
• If the average price level falls while money wages remain fixed, real wages rise, prompting firms to reduce output.
• The SRAS curve slopes upwards, with real output (Yr) on the horizontal axis and the average price level (APL) on the vertical axis.

The diagram below shows the SRAS curve. When the average price level rises from APL₁ to APL₂ while money wages stay fixed, real wages fall, firms become more profitable and they raise real output from Yr₁ to Yr₂.

Monetarist/New Classical long-run aggregate supply

In the long run, according to Monetarists and New Classical economists, economic factors can fully adjust, leading to a different aggregate supply behaviour compared to the short run.

Features of long-run aggregate supply

The long run allows money wages to be flexible, adjusting completely to changes in the average price level. For example, if the price level increases by 8%, money wages also rise by 8%, keeping real wages constant.

Characteristics of the LRAS curve:

• The long-run aggregate supply (LRAS) curve is vertical, indicating that shifts in the price level do not affect the total real output.
• This vertical curve is positioned at the economy's potential output level (Yp).
• At potential output, the economy experiences "full employment," but this includes natural unemployment, which occurs when the labour market is balanced.

The diagram below shows the LRAS curve drawn vertically at potential output Yp. A change in the average price level (APL) moves the economy up or down that same vertical line, so real output stays at Yp.

Factors shifting SRAS and LRAS

Various economic changes can cause the aggregate supply curves to shift, either increasing or decreasing the planned output at given price levels. These shifts differ between the short run and long run.

Factors shifting short-run aggregate supply

Changes in production costs or government policies can move the SRAS curve:

• Higher money wages - Shift SRAS left.
• Lower money wages - Shift SRAS right.
• Higher energy prices - Shift SRAS left.
• Lower energy prices - Shift SRAS right.
• Higher indirect taxes - Shift SRAS left.
• Lower indirect taxes - Shift SRAS right.
• Increased subsidies - Shift SRAS right.
• Decreased subsidies - Shift SRAS left.

The diagram below shows both directions. An increase in short-run aggregate supply shifts the curve right from SRAS₁ to SRAS₂, so firms plan more real output at every price level; a decrease shifts it left from SRAS₁ to SRAS₃.

Factors shifting long-run aggregate supply

Improvements in the economy's productive capacity cause the LRAS curve to shift, often leading to economic growth:

• Increased quantity of factors of production - For example, growth in labour supply through immigration shifts LRAS right.
• Improved quality of factors of production - Such as enhanced education and skills training, which shifts LRAS right.
• Technological advancements - Innovations that enable greater production capacity shift LRAS right.
• Greater efficiency - Better use of resources shifts LRAS right.
• Institutional reforms - Changes that reduce economic barriers, such as less bureaucracy, shift LRAS right.

Each of these raises the economy's productive capacity. The diagram below shows the result: the curve shifts right from LRAS to LRAS₁, and potential output rises from Yp to Yp₁.

The Keynesian approach to aggregate supply

Keynesian economists view aggregate supply differently, without separating it into short-run and long-run curves. They use a single aggregate supply curve (AS) that changes shape based on the economy's output level. The diagram below shows that curve and its three sections, numbered I, II and III.

Sections of the Keynesian aggregate supply curve

The curve has three distinct parts, reflecting varying economic conditions:

1. Section I, horizontal - At low output levels, the curve is flat. Firms can increase output without raising prices due to high unemployment and unused capacity.
2. Section II, upward-sloping - As output rises, bottlenecks emerge because some industries reach full capacity before others, causing prices to increase gradually.
3. Section III, vertical - At the full employment output (Yf), the curve becomes vertical. Output cannot expand further regardless of price changes.