2.3 aggregate supply

what is aggregate supply (AS)

Aggregate supply is the total supply of goods/services (real GDP) produced within an economy at a specific price level at a given time. (SRAS)

why is the AS curve upward sloping

• The AS curve is upward sloping because it is a combined supply of all supply curves, which are upward sloping (at a higher price level, producers are willing to supply more because they can earn more profits.).

• It is also because as real output increases, firms have to spend more to increase production e.g. wage bills will increase, may have to pay workers overtime if they do not hire more. Increased costs result in higher average prices

what is the theory of sticky wages

Sticky wages: Sticky wage theory argues that employee pay is resistant to decline even under deteriorating economic conditions. This is because workers will fight against a reduction in pay, and so a firm will seek to reduce costs elsewhere, including via layoffs, if profitability falls.

what causes a movement along AS

Movement: Only changes in the price level, which occur due to changes in AD, lead to movements along the AS curve. Think MOVEMENT = MONEY

If AD increases, there is an expansion in the SRAS, from Y1 to Y2. If AD falls, there is a contraction in SRAS, from Y1 to Y3.

what causes a shift of AS

Shift: The SRAS curve shifts when there are changes in the conditions of supply (non-price factors).

• The cost of employment might change, e.g. wages, taxes, labour productivity (affected by technological advancements)
• The cost of other inputs e.g. raw materials, commodity prices, the exchange rate if products are imported, supply shocks (wars, natural disasters, crop disease)
• Government regulation or intervention, such as environmental laws and taxes (VAT/excise), and business regulation. Business regulation is sometimes called 'red tape'.

what is the aggregate supply curve

The Aggregate Supply (AS) curve represents the total quantity of goods and services that producers in an economy are willing and able to supply at different price levels, ceteris paribus.

why is SRAS upwards sloping

In the short run (SRAS), the AS curve is upward sloping because:

• Prices of inputs (like wages) are sticky and do not adjust immediately to changes in the price level.
• Higher prices can temporarily increase profit margins, leading firms to increase production.

why is LRAS vertical

In the long run (LRAS), the AS curve is vertical at the full-employment level of output (potential GDP) because:

• In the long run, all prices, including wages, are flexible.

• Output is determined by factors such as technology, resources, and institutions, not by the price level. (shifts, not movements)

• All resources are fully employed so a shift in AD only affects price level

what do shifts in LRAS mean

LRAS Shifts: productive capacity of the ECONOMY - economic growth
Rightward Shift: Reflects long-term economic growth, such as increased capital stock, technological progress, or an increase in the labor force.

Leftward Shift: Reflects a decrease in an economy's productive capacity, such as due to destruction of capital or a decrease in the labor force.

Real-World Example: The COVID-19 pandemic caused a leftward shift in SRAS due to disrupted supply chains and labor market constraints.

what do shifts in SRAS mean

SRAS Shifts: short term fluctuations in production costs
Rightward Shift: Indicates an increase in aggregate supply. Causes include reductions in production costs, technological advancements, or improvements in productivity.

Leftward Shift: Indicates a decrease in aggregate supply. Causes include increases in production costs, supply shocks (e.g., natural disasters), or reduced productivity.

what is the relationship between SRAS and LRAS

Short-Run AS (SRAS):

• Prices of some inputs (like wages) are sticky and do not adjust immediately.
• Firms respond to higher prices by increasing output since they have higher profit margins.
• SRAS can be influenced by temporary factors like changes in production costs or expectations.

Long-Run AS (LRAS):

• All input prices are flexible, and the economy is at full employment.
• Reflects the economy's maximum sustainable output, given its resources and technology.
• Determined by factors like labor force size, capital stock, and technological innovation.

Connection:

• In the short run, deviations from full employment can occur, causing the SRAS to shift.
• In the long run, the economy adjusts to its potential output level, reflected by a vertical LRAS curve.

what factors influence SRAS (overview)

• changes in costs of raw materials and energy
• changes in exchange rates
• changes in tax rates

how do changes in costs of raw materials and energy influence SRAS

• Changes in the costs of raw materials and energy directly affect production costs for firms.
• Higher costs increase the overall cost of production, shifting the SRAS curve to the left as firms reduce output at existing price levels, shifting the SRAS curve leftward..
• Lower costs decrease production costs, shifting the SRAS curve to the right, as firms can produce more at lower costs, shifting the SRAS curve rightward.

Real-World Example:
2008 Oil Price Shock: The spike in oil prices led to increased costs for energy-dependent industries, shifting the SRAS curve leftward and contributing to global economic slowdown.

how do exchange rates influence SRAS

Exchange rates influence the cost of imported goods and services.

• A stronger domestic currency makes imports cheaper, reducing production costs and shifts SRAS to the right.
• A weaker domestic currency makes imports more expensive, increasing production and shifts SRAS to the left

Real-World Example:
Post-Brexit Pound Depreciation: The depreciation of the British pound after the Brexit referendum increased import costs for UK firms, shifting the SRAS curve to the left.

how do changes in tax rates influence SRAS

Changes in tax rates on businesses affect their cost structures and profitability.

• Higher tax rates increase costs, reducing supply. Firms reduce output at existing price levels, shifting the SRAS curve leftward
• Lower tax rates decrease costs, increasing supply. Firms can afford to produce more, shifting the SRAS curve rightward.

Real-World Example:
2018 US Tax Cuts and Jobs Act: The reduction in corporate tax rates in the US lowered production costs for businesses, contributing to a rightward shift in the SRAS curve.

what is LRAS

Long-run aggregate supply (AS) reflects the total output an economy can produce when all resources are fully employed.

what is the keynesian view of LRAS

• Emphasizes the existence of unemployment and idle capacity in the economy.

• Suggests that in the short run, output can be increased without causing inflation until full employment is reached.

• The economy can get stuck in a recessionary gap (below potential output) due to insufficient aggregate demand, and that government intervention was necessary to stimulate demand and restore full employment.

• Government intervention, such as fiscal policy, can help achieve full employment
  without causing inflation in the short run.

• Keynes argued that aggregate demand, not aggregate supply, is the primary driver of economic activity, especially in the short run - classical think that supply side drives economic activity.

Real-World Example: The Great Depression of the 1930s. High unemployment and unused capacity meant that increased government spending could boost output without causing inflation.

what is the keynesian lras curve explanation

Spare Capacity: When there is significant spare capacity (unemployment, idle factories), the aggregate supply curve is relatively flat (horizontal). This means that firms can increase production without significant price increases, as resources are readily available.

Intermediate Zone: As the economy approaches full capacity, the aggregate supply curve becomes upward-sloping. This means that as demand increases, firms can only increase output by raising prices, leading to inflation.

Full Capacity: Eventually, the aggregate supply curve becomes vertical, indicating that the economy has reached its potential output, and further increases in demand will only lead to inflation, not increased output.

what is the classical view of lras

The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic. The classical view suggests that real GDP is determined by supply-side factors - the level of investment, the level of capital and the productivity of labour e.t.c. Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP.

• Assumes the economy always operates at full employment in the long run.
• LRAS is vertical, implying output is fixed by supply-side factors.
• Markets adjust quickly due to flexible prices and wages.

Example: Germany's labour market reforms in the early 2000s helped maintain low unemployment, supporting the Classical view.

what factors influence LRAS (overview)

• technological advances

• changes in relative productivity

• changes in education and skills

• changes in government regulation

• demographic changes and migration

• competition policy

how do technological advances influence LRAS

Impact: Technological improvements increase productivity, allowing more output from the same input of labour and capital.

Examples:
The Industrial Revolution, which introduced machinery that enhanced production processes.
Modern-day advancements in information technology, which have streamlined communication and data management, boosting productivity across sectors.

how do changes in relative productivity influence LRAS

Impact: Increases in productivity in one sector relative to others can shift resources, optimizing the overall efficiency of the economy.

Examples:
The shift from manufacturing to service-oriented industries in advanced economies, driven by higher productivity in technology and finance sectors.
Agricultural productivity improvements in developing countries, freeing labor for industrial and service sectors.

how do changes to skills and education influence LRAS

Impact: A more educated and skilled workforce can produce more output and adapt to new technologies, enhancing long-run AS.

Examples:
Investments in STEM (Science, Technology, Engineering, and Mathematics) education leading to a more innovative workforce in countries like South Korea.
Vocational training programs in Germany that equip workers with specialized skills, increasing productivity.

how do changes to government regulation influence LRAS

Impact: Regulations can either constrain or enhance productivity. Deregulation can lead to increased efficiency, while excessive regulation can stifle innovation and growth.

Examples:
Deregulation of the airline industry in the United States in the late 1970s, which increased competition and efficiency.
Stringent environmental regulations in the European Union that, while protecting the environment, may increase production costs in certain industries.

how do demographic changes and migration influence LRAS

Impact: Population growth, aging, and migration patterns significantly affect the labor supply and thus long-run AS.

Examples:
Japan's aging population leading to a shrinking workforce and lower potential output.
Migration influxes in the United States and Germany, contributing to a growing labor force and economic expansion.

how does competition policy influence LRAS

Impact: Policies that promote competition can lead to more efficient markets and higher productivity.

Examples:
Antitrust laws in the United States that prevent monopolies and promote competitive markets.
The European Union's policies to reduce barriers to entry in various industries, fostering innovation and efficiency.