Economic Environment

Course book

Aggregate supply

Prof Ashok Thomas

IIM Kozhikode
Introduction
Throughout this module, you will visit Econoland, a place created to illustrate macroeconomic
challenge concepts. You will learn from the experiences of the people in Econoland. Enjoy your
visit!

This unit will help you understand the concept of aggregate supply in both the short-run and
the long-run. Aggregate supply relates to the real value of the goods and services supplied by
all producers in the economy. Clearly, this value will be sensitive to quantity of inputs (e.g.,
labor and machinery) used and the state of technology.

You will examine the three possible shapes of the aggregate supply curve—horizontal (a fixed-
price case relevant in the more immediate time frame), upward sloping (or short run), and
vertical (long run or Classical) —based on the underlying assumptions made. A horizontal
aggregate supply curve assumes a fixed prices. An upward sloping aggregate supply curve
assumes that input costs and inflationary expectation are sticky or unchanging in the short run.
And a vertical aggregate supply curve assume flexibility of input prices and inflationary
expectations.

There are factors that shift the short-run aggregate supply curve. If productivity, input prices,
or inflationary expectations change the short-run aggregate supply curve will shift.
Additionally, you will discover that the long-run aggregate supply curve is vertical. This is
because input prices and inflationary expectations are fully flexible in the long run. This
vertical long-run aggregate supply curve can shift with changes in the quantity and or quality
of inputs changing or with changes in technology. At any point in time, this long-run aggregate
supply curve measures the potential real GDP or the economy. This leads to introducing the
concept of economic growth or an increase in the maximum sustainable potential real GDP of
the economy.

An understanding of short-run and long-run aggregate supply, coupled with aggregate demand,
permits you to analyze the short-run and long-run economic performance of the aggregate
economy.

Practical Application
Think of all of the many types of businesses that you see around you. This concept of aggregate
supply gives you a way to understand the overall impact of these firms on economic activity.

Sometimes you look at individual firms and the way they function, but sometimes it is helpful
to consider them in the aggregate. For instance, changes in key input costs or changes in
productivity will have an impact on most firms, and you can then predict the impact on
economic activity in both the short run and the long run.
Learning Objectives
You will learn how to construct a short-run aggregate supply curve and a long-run aggregate
supply curve, and you will learn the assumptions for both curves.

You will also learn the determinants of each curve and be able to illustrate changes in these
determinants with your aggregate supply curves.

You will then be able to use these components of an aggregate supply and demand model for
macroeconomic analysis.

Short run aggregate supply

In this activity, you will understand the assumptions behind and determinants of short-run
aggregate supply (SRAS) and be able to use these for analysis. You will be able to graph
the SRAS and appropriately shift the curve when relevant changes occur.

A graph of aggregate supply has the aggregate price level in the economy on the vertical axis
and real gross domestic product (GDP) on the horizontal axis. The aggregate price level may
be expressed as an index—say, 100 in the base year. A 10 percent increase in prices would thus
increase the index to 110. Real GDP is measured in dollars.

Let's begin with a very special case of the aggregate supply curve. This case—referred to as a
fixed-price case, immediate case, or simple Keynesian case—has a perfectly horizontal
aggregate supply curve. Firms can and will increase levels of output without output price
increases to motivate such production increases. Economists feel that this horizontal aggregate
supply curve is relevant only at low levels of output, compared to the full employment output
level. Within an economy with output well below potential, firms—eager for sales—will
increase output without corresponding output price increases.

More likely, in the short run, firms will require an increase in prices to increase real output.
Thus the short-run aggregate supply curve will be upward sloping. The positive relationship
between the price level and the quantity of real GDP supplied can be explained in two ways:
1. With a fixed nominal wage and diminishing marginal product of labor, firms must be offered
price increases to find it profitable to hire more labor and to produce more output. Thus, higher
price levels are needed to increase the aggregate output level.

2. With a fixed nominal wage, a higher price level leads to a reduction in the real wage. With
a reduction in the real wage, firms find it attractive to hire more labor and to produce more
output.

An increase in the short-run aggregate supply curve (or a shift of the curve to the right) means
that any level of real GDP can now be produced with a lower price level. The short-run
aggregate supply curve will increase or shift to the right with a reduction in any input price or
an increase in productivity. Such a shift is called a positive supply shock, as there will be a
lower aggregate price level associated with each level of real GDP.

A decrease in the short-run aggregate supply curve (or a shift of the curve to the left) means
that any level of real GDP must now be produced with a higher price level. The short-run
aggregate supply curve will decrease or shift to the left with an increase in any input price or a
decrease in productivity. Such a shift is called a negative supply shock, as there will be a higer
aggregate price level associated with each level of real GDP.
Activity 1

Now assume that in Econoland, input costs decline.

a) draw the new SRAS curve.

Now assume that in Econoland, labor productivity declines.

b) draw the new SRAS curve.

Activity 2

Draw a short-run aggregate supply curve for each of the following scenarios and show the
appropriate change.

i. increase in the price level

ii. decrease in business taxes
iii. increase in business regulations
iv. decrease in the price of all forms of energy
v. decrease in the availability of natural resources

Conclusion
You should now understand the assumptions of the short-run aggregate supply curve. Well
below full employment wages and prices may be sticky or fixed. In this case, the short-run
aggregate supply curve will be horizontal, called the fixed-price case. This is a very Keynesian
perspective.

More generally, the short-run aggregate supply curve will be upward sloping. A higher price
level is needed to induce a greater quantity of real GDP. You should also know the determinants
of short-run aggregate supply and be able to explain changes in short-run aggregate supply
from changes in the factors. For instance, a decrease in the wage rate would increase aggregate
supply or shift it to the right. Each level of real GDP is now associated with a lower price level.
Multiple Choice Questions

Question 1) If a short-run aggregate supply curve is upward sloping, what is assumed about
inflationary expectations?
a) Inflation expectations are held constant.
b) Inflationary expectations are fully flexible.
c) Inflationary expectations vary directly with output prices.
d) Inflationary expectations vary indirectly with output prices.
e) Inflationary expectations increase more quickly than output prices.

Question 2) If the price of a key input like oil decreases, what would happen to short-run
aggregate supply and employment?

a) Short-run aggregate supply would shift right and employment would decrease.
b) Short-run aggregate supply would shift left and employment would decrease.
c) Short-run aggregate supply would remain the same and employment would increase.
d) Short-run aggregate supply would shift right and employment would increase.
e) Short-run aggregate supply would shift left and employment would increase

Question 3)In the short run, what happens to aggregate supply when business taxes increase?

a) shifts to the left

b) shifts to the right
c) remains the same
d) becomes vertical
e) becomes horizontal

Long run aggregate supply

In this part of the lesson, you will learn the assumptions of a long-run aggregate supply curve
and how to construct this curve.

The long-run aggregate supply curve represents potential output at full employment. In the
long run, all input prices and output prices are flexible and competitive. As a result, there will
be full employment of resources and all the output produced will be sold. The economy will
be at its long-run maximum sustainable level of output—often called potential output, or the
full-employment level of real GDP. The long-run aggregate supply curve (LRAS) will be
vertical. Thus, this maximum sustainable output level is invariant to the price level, or
perfectly inelastic.

The quantity of inputs and the state of technology will determine the actual level of potential
output. In the short run, production may occur at a level of real GDP either above or below
potential GDP. However, we assume that such a level of output is not sustainable and that the
economy will move to the full-employment potential output in the long run.

At this full employment level of real GDP, there will be no involuntary (or cyclical)
unemployment. There will be individuals voluntarily unemployed, moving between jobs.
This frictional unemployment is the unemployment that is included in the full-employment
unemployment rate, often called the natural rate of unemployment—typically estimated as
between 4.5% and 5.5%.

The LRAS represents economic potential, as does a production-possibilities curve. An

increase in long-run aggregate supply (or a shift of the curve to the right) represents an
increase in the potential of the economy, showing economic growth. Factors that can cause
increased long-run aggregate supply (LRAS) include technological progress—or productivity
increases—as well as increases in the quantity and/or quality of natural resources, human
resources, or capital resources. Because the long-run aggregate supply curve illustrates the
same concept as the production-possibility frontier, when economic growth occurs, these
curves shift (to the right for LRAS and outward for PPF). Long-run aggregate supply can
decrease (or shift to the left) with decreases in the quantity and/or quality of natural
resources, human resources, or capital resources. Also, with any long-run decrease in
productivity, the LRAS would shift to the left.

Question 1) In Econoland, there is a strong increase in business confidence and increases in

inputs for manufacturing and energy. What effect, if any, will this have on LRAS?

a) Increase
b) Decrease
c) Remain the Same

Question 2) In Econoland, there is 7-year period of annual business tax and property tax
increases. What effect, if any, will this have on LRAS?

a) Increase
b) Decrease
c) Remain the Same

Question 3) Which of the following combinations would cause an increase in LRAS?

a) decrease in capital stock and increase in productivity

b) increase in property taxes and productivity
c) increase in capital stock and increase in productivity
d) decrease in capital stock and decrease in productivity
e) increase in business taxes and increase input prices

Activity 1
In Econoland, there is a sudden discovery of a new source of clean, efficient energy. Draw a
long-run aggregate supply curve (LRAS) and show the effect that this discovery would have
on the LRAS. Explain your reasoning.

Compare your graph and give explanation to the ones given below.

Question 4) Long-run aggregate supply represents:

a) potential output at full employment.

 b) actual nominal output.
c) spending from all sectors of the economy at various price levels.
d) actual output at zero unemployment.
e) potential output at zero unemployment.

Question 5) Changes in which of the following determinants would shift both short-run and
long-run aggregate supply?

a) wages
b) inflation expectations
c) business taxes
d) technology
e) oil prices

Question 6) Which of the following would decrease long-run aggregate supply?

a) increases in imports
b) increases in wealth
c) decreases in government spending
d) decreases in inflationary expectations
e) decreases in the capital stock

Question 7) What is the reason that the long-run aggregate supply curve shows no
relationship between the price level and output?

a) Input prices are flexible, but output prices are inflexible.

b) Input prices are flexible, but inflation expectations are inflexible.
c) Some input prices are flexible and some are inflexibile.
d) All input prices and inflation expectations are fully flexible.
e) Both input prices and inflation expectations are inflexible.

Question 8) A decrease in the price of inputs will cause which of the following to occur in
the short run?

a) an increase in the aggregate demand and an increase in the price level

b) a decrease in the aggregate demand and an increase in the price level
c) an increase in the short-run aggregate supply and a decrease in the price level
d) an increase in the short-run aggregate supply and an increase in the price level
e) a decrease in the short-run aggregate supply and a decrease in the price level

Question 9) An increase in which of the following is consistent with an outward shift of the
production-possibilities curve?

a) transfer payments
b) aggregate demand
c) long-run aggregate supply
d) income tax rates
e) exports
Assignment

Assume that the United States economy is currently operating at an equilibrium below full
employment.

A. Draw a correctly labeled graph of aggregate demand and aggregate supply, and show
each of the following.

(i) Long-run aggregate supply

(ii) Current equilibrium output and price level

B. Now assume a significant increase in the world price of oil, a major production input for
the United States. Show on your graph in part (a) how the increase in the oil price affects
each of the following in the short run.

(i) Short-run aggregate supply

(ii) Real output and price level

C. Given your answer in part (b), explain what will happen to unemployment in the United
States in the short run.

Conclusion

You should now recognize that the long-run aggregate supply curve represents potential
output at full employment. In the long run, all input prices and output prices are flexible and
competitive. As a result, there will be full employment of resources and all the output
produced will be sold. This means that the long-run aggregate supply curve (LRAS) will be
vertical. Thus, this maximum sustainable output level is invariant to the price level. Also,
economic growth can be shown as a rightward shift of the long-run aggregate supply curve,
showing a higher maximum sustainable output level