Aggregate Supply
What is Aggregate Supply?
Aggregate supply is the total supply of final goods and services in an economy at a given time.
Aggregate supply represents the total amount of goods and services that firms plan to produce and sell at a given price level. In the short run, aggregate supply can increase or decrease with changes in the price level. In the long run, aggregate supply is determined by an economy's factors of production.
Aggregate Supply: a worked example
Build a short-run aggregate supply schedule. Firms plan to produce $760 billion at a price level of 100, $790 billion at 105 and $820 billion at 110. Aggregate demand runs the other way: $760 billion at 100, $730 billion at 105 and $700 billion at 110. Equilibrium is a price level of 100 with output of $760 billion. Now imported oil becomes more expensive, per-unit production costs rise, and firms plan $60 billion less output at every price level: $700 billion at 100, $730 billion at 105 and $760 billion at 110. The two schedules now match at a price level of 105 with output of $730 billion. Output fell $30 billion while the price level rose 5 points, the signature pattern of a negative supply shock.
The mistake students make with aggregate supply
A wage increase makes many students shift SRAS right, reasoning that better-paid workers produce more. Wages are a cost to firms, so higher nominal wages raise per-unit production costs and shift SRAS left, pushing the price level up and output down. The second recurring error is shifting SRAS for a change in total input spending rather than a change in cost per unit. Firms hiring more workers because output is expanding are moving along SRAS, not shifting it. Only a change in what each unit costs to produce moves the curve.
Aggregate Supply questions
Why does short-run aggregate supply slope upward?
Nominal wages and many input prices are fixed by contract in the short run. When the price level rises, output prices climb faster than these sticky costs, per-unit profit widens, and firms expand production. A falling price level squeezes profit against unchanged wages and firms cut back. Once contracts are renegotiated and input prices catch up, that profit incentive disappears, which is why the long-run curve is vertical.
What shifts the aggregate supply curve?
Input prices, productivity, per-unit business taxes and subsidies, and supply shocks shift short-run aggregate supply. Cheaper energy or a productivity gain moves SRAS right, while higher nominal wages, a poor harvest or a new per-unit tax moves it left. Long-run aggregate supply moves only for the subset of those changes that alters productive capacity, such as a lasting productivity gain, and not for a temporary jump in input prices.
What does stagflation look like on an aggregate supply graph?
Stagflation appears as a leftward shift of short-run aggregate supply. Output falls and the price level rises at the same time, a combination no shift in aggregate demand can produce, since an AD shift moves output and the price level in the same direction. Rising input costs are the usual cause, and policymakers face a trade-off because fighting the inflation with contractionary policy deepens the output loss.
This is the live AD/AS Model sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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