Aggregate Supply Notes

Aggregate Supply

Introduction

  • Unlike demand, there are two aggregate supply curves: short-run and long-run.
  • Aggregate means to add everything up; the aggregate supply curve represents the total supply of goods and services in the entire economy.

Short-Run Aggregate Supply (SRAS)

  • Definition: The total quantity of goods and services firms are willing and able to supply at different price levels in the short run.
  • Shape: Upward sloping.
  • Explanation: As the price level increases, producers have an incentive to produce more due to increased profit potential. Conversely, as the price level decreases, producers reduce output due to decreased profit.

Shifts in SRAS

  • Just like market supply curves, the SRAS curve can shift.
  • An increase in SRAS shifts the curve to the right.
  • A decrease in SRAS shifts the curve to the left.
Shifters of SRAS:
  1. Change in Resource Prices:
    • If the price of resources (e.g., raw materials, labor) increases, SRAS shifts to the left (less production at each price level).
    • If the price of resources decreases, SRAS shifts to the right (more production at each price level).
  2. Actions by the Government:
    • Taxes: Higher taxes increase production costs, shifting SRAS to the left.
    • Subsidies: Subsidies decrease production costs, shifting SRAS to the right.
    • Regulations: Stricter regulations can increase production costs, shifting SRAS to the left.
    • Note: Government spending is a shifter of aggregate demand, not aggregate supply.
  3. Change in Productivity:
    • Technological advancements allow for more output per input, shifting SRAS to the right.
Important Terms

  • Capital Stock: The amount of physical capital (tools, machines, and factories) available in the economy. Note: Capital refers to physical tools, not money.

  • Supply Shock: An unexpected change in the price or availability of a key resource.

    • Negative Supply Shock: A decrease in the availability of resources, shifting SRAS to the left.
    • Positive Supply Shock: An increase in the availability of resources, shifting SRAS to the right.
Change in Expected Price Level
  • A change in the price level itself does not shift the SRAS curve; it causes a movement along the curve.
  • However, a change in the expected price level does shift the SRAS curve.
  • If people expect higher prices/inflation in the future, resource costs and wages will increase, shifting SRAS to the left.
  • Workers will negotiate for higher wages to maintain their purchasing power if they expect inflation.

Long-Run Aggregate Supply (LRAS)

  • Definition: The total quantity of goods and services the economy can produce when all resources are fully employed.
  • Shape: Vertical.
Relationship between SRAS and LRAS
  • In the short run, changes in the price level affect output along the SRAS curve.
  • However, in the long run, wages and resource prices adjust to the new price level.
  • If the price level increases, firms initially increase output (movement along SRAS). But eventually, wages and resource costs rise, shifting SRAS to the left. The economy returns to the LRAS.
  • If the price level decreases, firms initially decrease output. But eventually, wages and resource costs fall, shifting SRAS to the right. The economy returns to the LRAS.
  • The LRAS represents full employment and the economy's maximum sustainable capacity.
Connection to Production Possibilities Curve (PPC)
  • The LRAS is analogous to the Production Possibilities Curve learned in introductory economics.
  • Both represent the maximum sustainable capacity of the economy and the amount produced at full employment.
  • Anything that shifts the PPC (e.g., more resources, better technology) would also shift the LRAS.

Scenarios and Practice

  1. Nominal wages increase: SRAS decreases (shifts left) due to increased resource costs.
  2. More physical capital: SRAS increases (shifts right) due to increased productive capacity.
  3. Power outages: SRAS decreases (shifts left) because of fewer available resources (negative supply shock).
  4. Decrease in corporate taxes: SRAS increases (shifts right) because producers have more money to produce.
  5. People expect higher prices in the future: SRAS decreases (shifts left) because costs will increase for wages and resources.
Important Distinction: Short Run vs. Long Run
  • Always pay attention to whether a question refers to the short run or the long run.
  • Example: An increase in nominal wages does not affect LRAS because, in the long run, the economy will produce at full employment regardless of wage levels.
  • However, an increase in physical capital does shift LRAS to the right, representing an increase in the economy's potential output.

Conclusion

  • The short-run aggregate supply curve is upward sloping and represents the immediate response of firms to price level changes.
  • The long-run aggregate supply curve is vertical and represents the economy's potential output when all resources are fully employed and prices/wages have fully adjusted.
  • Practice is essential to master aggregate supply concepts.