Aggregate Supply

Why the SRAS Curve Slopes Upward

You should be able to visualize how the curves change, and understand the difference between the short-run's 'stickiness' and the long-run's vertical line, because this difference is important for answering any question about macro policy.

The short-run aggregate supply (SRAS) curve is upward-sloping for one main reason: wages and other costs of production don't instantly adjust when the general price level goes up.

Imagine prices generally going up by 10%. Companies are still paying the wages they agreed to last quarter. Their revenue per item has increased, but labor costs haven't changed, so their profits increase and they produce more. If you think about this happening in every factory, restaurant, and office in the country, you'll see a connection where higher prices mean higher total production.

Two explanations for this are tested on the AP exam.

The sticky wage theory says employment contracts 'lock in' wages. When prices increase but wages don't keep up, it becomes cheaper to employ people in terms of real value - the business gets more revenue from each item, but payroll hasn't gone up. Therefore, companies employ and produce more. Employees aren't immediately going to ask for a raise because of their contracts, or they may not have yet realised that prices have generally increased. This seems odd, but contracts do have a length. For example, Ford or GM might have a three year agreement with their union.

The misperceptions model is different. A wheat farmer sees wheat prices rising and thinks demand for her wheat has specifically increased. She plants more. But in fact, all prices are increasing; it's a general inflation, and not something to do with wheat. She increases production because she's incorrectly assumed the general price level has risen is a change in the price of wheat relative to other things.

Both of these explanations come to the same conclusion: a higher price level leads to more production in the short term because the costs of production, especially wages, haven't adjusted.

What Shifts SRAS

The SRAS curve shifts to the left or right when costs of production change throughout the whole economy; this is different from moving along the curve as a response to price level changes.

The biggest factor in production costs is input prices. When oil prices dramatically increase, as they did in 1973, 1979, and early 2022, costs go up for transport, manufacturing, farming, chemicals... pretty much everything. SRAS shifts left. When commodity prices fall, it goes the other way. The AP exam really likes oil price increases as a way to shift SRAS, and it's easy to see why - oil is used in almost all production.

Improvements in productivity shift SRAS to the right. If employees produce more per hour because of better tech, better training or more effective systems, the cost per item falls. At every price level, more can now be produced. The US saw SRAS shift to the right significantly during the late 1990s tech boom; computerisation increased productivity growth to about 3% a year, about twice the typical rate.

Supply shocks are sudden, and often big. Hurricane Katrina destroying oil refineries on the Gulf Coast in 2005, COVID closing factories globally in 2020, Russia invading Ukraine and interrupting grain exports in 2022. All of these pushed SRAS to the left. A positive shock, like the 'fracking revolution' that lowered US natural gas prices after 2008, pushed SRAS to the right.

Government rules and taxes on production also have an effect. A new EPA rule increasing the cost of complying with regulations for manufacturers shifts SRAS left. A specific payment to encourage semiconductor production, like the 2022 CHIPS Act, shifts it right.

Students frequently get the curves mixed up on AP Macroeconomics free response questions. Demand-side things – how confident people are, government spending, the amount of money available – move the AD (aggregate demand) curve. On the other hand, things affecting the costs for businesses, how much they get out of each worker, and sudden disruptions shift the SRAS (short-run aggregate supply) curve. And getting these two confused will always lose you a point on the explanation.

The Long-Run Aggregate Supply Curve

The Long-Run Aggregate Supply curve (LRAS) is a vertical line. Eventually, all prices that don't change easily do change. Contracts are renewed, employees ask for pay increases that match actual inflation, and companies change the price of what they sell. Once all of this happens, the amount the economy produces relies solely on how much it can actually produce, considering the number of workers, the equipment and buildings they use, and the level of technology. How much the economy makes isn't influenced by the price level at all. That's why the LRAS is a straight up and down line.

LRAS is at potential GDP, sometimes called full-employment output. This is the greatest amount the economy can sustainably make when all resources are used at their normal rates. "Full employment" can be confusing; it doesn't mean absolutely no one is unemployed. Instead, it means unemployment is at the "natural rate", which includes people between jobs (frictional) and people whose skills don't match available jobs (structural), but not unemployment due to a weak economy (cyclical). The natural unemployment rate in the U.S. has been around 4-5% for many years.

What causes the LRAS to shift? Only changes in the economy's actual ability to produce. This could be a bigger workforce, perhaps due to more people moving to the country or more people looking for work. It can be more equipment and buildings from ongoing business investment. It can be important advancements in technology that let each worker make more. Or it can be improvements to systems like education or how securely people can own property. Changes in the price level don't have an effect on LRAS; it doesn't move.

Self-Correction and the Output Gaps

When actual GDP is below the LRAS line, the economy has a recessionary gap - production is lower than it could be and unemployment is higher than the natural rate.

The economy corrects itself through wages. When lots of people are out of work, they really compete for the few available jobs. Over time, wages either fall or don't increase as much as they would have. Lower wages lower the cost of making things for all businesses, so SRAS shifts to the right. This shift continues until production reaches potential GDP, and the price level is lower than it was originally.

An inflationary gap corrects in the opposite way. When actual GDP is above potential, the job market is very competitive, workers have power, and they ask for higher pay. Increasing wages mean increasing costs, SRAS moves to the left, and production decreases back to the LRAS line. The price level, however, is now permanently higher.

The main argument in macroeconomics is about how quickly this self-correction happens.

Classical economists think the adjustment is fast enough that government involvement usually causes more problems. Keynesians say wages are incredibly slow to go down; workers and unions strongly oppose pay cuts, and with good reason. A really deep recession could mean years of high unemployment if you just wait for the economy to fix itself. The Great Depression lasted over ten years before government spending during the war ended it. The 2001 recession fixed itself in about eighteen months. How bad the downturn is decides if "just wait" is a sensible plan or simply sounds uncaring.

Historical Supply Shocks

The 1973 oil embargo by OPEC is the standard example of a bad supply shock. Oil prices went up four times over almost immediately, and then the Iranian Revolution in 1979 interrupted the supply again, roughly doubling prices. Because oil is used in almost all production, SRAS shifted sharply left both times. Stagflation is when prices go up at the same time that the amount of stuff the economy makes is going down. Most economists before the 1970s really thought inflation and a downturn in the economy couldn't happen simultaneously, because the Phillips Curve suggested they always moved in opposite directions. Stagflation proved that wrong and meant economists had to completely rethink how the overall economy works.

The COVID-19 pandemic in 2020 and 2021 created a very different sort of problem with supply, but with some similar outcomes. Factories in Asia closed. Loads of shipping containers, thousands in fact, were stuck off the coast of Long Beach, California. The lack of semiconductors globally stopped Ford, GM, and Toyota from making cars for months at a time. Many people stopped looking for work altogether. Short-Run Aggregate Supply (SRAS) sharply moved to the left. Meanwhile, the $1200 and $1400 stimulus checks, and an extra $600 per week in unemployment benefits, pushed Aggregate Demand (AD) to the right. This combination of drastically reduced supply and increased demand is what caused inflation to jump to over 8% by the middle of 2022.

The lesson from both of these periods is the same: you deal with problems caused by how much people want to buy (demand) differently than problems caused by how much is available to buy (supply). A recession caused by a fall in demand can be dealt with by stimulating the economy, with more government spending or lower interest rates. But a problem with supply is much harder. Boosting demand when there isn't enough supply just adds to the inflation in an economy that is already having a difficult time.

Worked Example: SRAS Shift

Let's look at an example of SRAS shifting and finding a new balance.

Initially the economy is at its best long-run point with prices at 110 and real GDP at $5 trillion, sitting exactly on the Long-Run Aggregate Supply (LRAS) line. Actual GDP and potential GDP are the same. Then an oil price shock happens.

This shock increases costs for all businesses, moving SRAS to the left. The new short-run balance will be at a price level of 120 and a real GDP of $4.6 trillion.

What's the gap? Potential GDP is $5 trillion, actual GDP is $4.6 trillion. Actual is less than potential, and that's a recessionary gap of $400 billion.

What does this look like on a graph? Three things occur at once. Prices rise from 110 to 120, output falls from $5 trillion to $4.6 trillion, and there's an area of 'deadweight loss' between the old and new equilibrium points. Prices going up and production going down: that's stagflation as described in textbooks.

The economy will correct itself. Because GDP is below its potential, unemployment will be higher than the 'natural' level. Over time, this higher unemployment will push wages down. Lower wages lower production costs, so SRAS will slowly move back to the right. The economy will move along the AD curve toward $5 trillion, and prices will fall from 120.

The difficult thing about a negative supply shock is that the correction process means living with both high prices and high unemployment for a long time, perhaps years. Increasing AD would quickly close the output gap but make inflation even worse. Reducing the money supply to fight inflation would make the recession deeper. Neither of these 'demand-side' methods solves both issues at the same time. This is the exact situation the Federal Reserve was in in 2022, and it's the same situation Arthur Burns had in 1974.