AGGREGATE DEMAND AND AGGREGATE SUPPLY UNIT

AGGREGATE SUPPLY INTRODUCTION AND OVERVIEW

IB CORE CONCEPTS AND NOTES SPECIFICALLY RELATED TO THIS VIDEO

IB Core Concept Standard Level and High Level Concept

Aggregate Supply The Meaning of Aggregate Supply
• Define the term aggregate supply.
• Explain, using a diagram, why the short-run aggregate supply curve
(SRAS curve) is upward sloping.
• Explain, using a diagram, how the AS curve in the short run (SRAS)
can shift due to factors including changes in resource prices,
changes in business taxes and subsidies and supply shocks.
Alternative views of Aggregate Supply
• Explain, using a diagram, that the monetarist/new classical model
of the long- run aggregate supply curve (LRAS) is vertical at the
level of potential output (full employment output) because
aggregate supply in the long run is independent of the price level.
• Explain, using a diagram, that the Keynesian model of the
aggregate supply curve has three sections because of “wage/price”
downward inflexibility and different levels of spare capacity in the
economy.
Shifting the aggregate supply curve over the long term
• Compare and contrast, using the two models above, the ways that
factors leading to changes in the quantity and/or quality of factors
of production (including improvements in efficiency, new
technology, reductions in unemployment, and institutional
changes) can shift the aggregate supply curve over the long term.
Source: IB Economics Subject Guide

Overarching Idea: The concept of the “supply side” of the economy is extremely important in
the study of overall productive capacity of the economy.

Aggregate Supply
▪ Definition: aggregate supply is the total amount of goods and service that all industries
in the economy will produce at every given price level in a particular time frame.
▪ It is essentially the sum of the supply curves of all the industries in the economy.
▪ In contrast to the theory of aggregate demand, here we distinguish between the short-
run and the long-run in looking at aggregate supply.

Short-Run Aggregate Supply (SRAS)

▪ The short-run aggregate supply curve looks very much like a microeconomic supply
curve in that it is upward-sloping.
▪ There is a positive relationship between price level and the amount of output that a
country’s industries will supply.
▪ Here’s the diagram:
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▪ Definition of short run: in our macroeconomic analysis, the short run is defined as the
period of time when the prices of the factors of production do not change.
o IMPORTANT: the price of labor—the wage rate—is fixed!
▪ If a larger level of output is to be produced firms are likely to face higher average cost of
production.
o Example: in order to produce more, firms will have to provide incentives to
workers to produce a larger amount.
▪ Most commonly this is done by paying “overtime” wages.
▪ In the short run then, an increase in output will be accompanied by increased in average
costs.
▪ Industries will pass on an increasing cost in the form of the higher price level.
▪ This explains why the SRAS curve is upward sloping.

▪ Shifts in the Short Run Aggregate Supply Curve (SRAS)

o Definition: The SRAS curve shows the relationship between the average price
level and the level of national output under the ceteris paribus assumption—we
assume that the factor of production costs remains constant.
o Change in the price level results in the change in the level of output and is shown
as a movement along the SRAS curve.
o A change in anything other than the price will lead to a shift in the whole
aggregate supply curve.
▪ KEY: the change in any of the factors other than price level will result in a
shift in the SRAS curve.
o These shifts maybe referred to as “supply-side shocks”.
▪ Definition: the most straightforward explanation of supply-side shocks is
that they are factors that cause changes in the cost of production.
▪ Similar to our microeconomic analysis, a decrease in costs results in an
increase in aggregate supply, while increasing costs results in a decrease
in aggregate supply.
▪ Examples of Changes in Costs of Production or “Supply Side Shocks”:
• A change in wage rates:
o An increase in wages will result in an increase in the cost
of production to firms and therefore a fall in aggregate
supply.
o Example: an increase in the minimum wage.
• A change in the cost of raw materials:

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 o For a change to have an effect on aggregate supply we are
assuming increasing the price of significant widely used
raw materials, such as oil.
• A change in the price of imports:
o If the capital or raw materials used by a country’s
industries are imported, then a rise in import prices will
increase the cost of production.
o This can occur due to changes in the exchange rate of a
country’s currency.
→ Example: if the value of the euro falls then this
makes the import price of raw materials and capital used
by European producers relatively more expensive, raising
their costs of production.
• Change in government indirect taxes or subsidies:
o An increase in indirect taxes effectively increases the cost
of production to firms and therefore results in a fall in the
SRAS curve.
o Conversely, a fall in indirect taxes will result in an increase
in the SRAS curve.

Source: Jocelyn Blink and Ian Dorton. IB Economics: Course Companion, Second Edition.