Aggregate Supply

What you should know by the end of this chapter:

●Defining aggregate supply

• Short-run aggregate supply (SRAS) curve
• Determinants of short-run aggregate supply
• Changes in short-run aggregate supply
• Short-run equilibrium national income
• Monetarist/new classical view of the long-run aggregate supply curve (LRAS) curve
• Long-run equilibrium at full employment level of output
• Inflationary and deflationary/recessionary gaps
• Keynesian view of the aggregate supply curve
● Equilibrium in the Keynesian model
• Changes in aggregate supply over the long run
 Definition of aggregate supply
Aggregate supply is the total quantity of all goods and services the economy can
produce at a given price level and in a given time period.

Aggregate supply adds together the supply of goods from all the markets in the
economy.

Aggregate supply is made up of the output of all the different types of producers
in the economy from small and medium-sized enterprises (SMEs) up to
multinational corporations (MNCs) and state-run industries.
Short Run Aggregate Supply
(SRAS)
Definition of
the short run:
The short-run aggregate supply curve
There is a positive relationship
The short-run in between the average price level and
the short-run aggregate supply curve.
this model is the
As the average price level rises firms
time period when will increase output to take
advantage of higher profits from a
the price level in
higher price level and a higher price
the economy can covers the cost of increasing output.
Diagram 3.5 shows how an increase
change but the
in the average price level from P to
cost of factors of P1 leads to a movement along the
short-run aggregate supply curve and
production is held
real output increases from Y to Y1.
constant.
 Changes in the short-run aggregate supply
The short-run aggregate supply curve will shift
if there is a change in business costs brought
about by a change in the price of resources.

If wage rates or the cost of raw materials fall

then the short-run aggregate supply curve will
shift to the right from SRAS to SRAS 1 in
diagram 3.6.

If wage rates rise or the cost of raw materials

rises, then the short-run aggregate curve will
shift to the left from SRAS to SRAS 2 in diagram
3.6.
Changes in indirect taxation can also cause shifts in the short-run aggregate
supply. If a country increases its rate of VAT from 20 per cent to 25 per cent
then aggregate supply will fall and the short-run aggregate supply curve will
shift to the left.
Short-run The short-run equilibrium national income is the
real GDP of a country determined by the

equilibrium interaction of short-run aggregate supply and

aggregate demand.

national When aggregate demand equals short-run

aggregate supply in the economy achieves the

income equilibrium national income (real GDP) and the

equilibrium average price level.
 Change in aggregate demand
Changes in short-run A reduction in income tax on
equilibrium: households leads to a rise in their

A change in either disposable income. This leads to an

aggregate demand or increase in consumption and a rise in

aggregate demand.
supply will cause a
change in the The aggregate demand curve shifts

equilibrium level of from AD to AD1 in diagram 3.8

leading to a rise in the average price
national income (real
level from P to P1 and an increase in
GDP).
real GDP from Y to Y1.
Change in short-run aggregate supply
In this case short-run aggregate supply might
fall and shift to the left because of a rise in the
minimum wage in an economy which increases
business costs.

This causes SRAS to shift to SRAS1 in diagram

3.9 and the equilibrium real GDP falls from Y
to Y1 and the equilibrium average price level
rises from P to P1.
Keynesian and Neo-Classical
Long-run aggregate supply
(LRAS)
 Definition of the long-run
The long-run in this model is the time period when the price level in the economy
can change and the cost of factors of production can change.

This means short-run changes in aggregate demand and supply can lead to changes
in the costs of factors of production which cause further adjustments in the average
price level and real GDP.
New classical LRAS
 Long-run aggregate
supply at full employment
The long-run aggregate supply curve is vertical at the full employment
level of national income because Monetarist/Neo-classical economists
believe the short-run equilibrium level of national income will always
adjust towards full employment in the long run. This adjustment process
can be looked at from two short-run equilibrium situations.
Perspective: they have the perspective and belief in the efficiency of market
forces and their view that there should be very minimum of government
intervention in the allocation of resources in the economy.

- In this view LRAS curve is PERFECTLY INELASTIC, as shown in the following

graph. This is known as “full employment level of output.
This is the level of national income where all resources available in
the economy are being fully utilised.

We normally talk about this in terms of full utilisation of labour and

capital. In reality, there is never zero unemployment or full utilisation
of productive capacity such as shops, office space and factories.

As shown in the graph, the price level might be rise from P1 to

P2, but the level of output does not change
Movements of the long-run aggregate supply curve
The long-run aggregate supply curve will shift if
there is a change in the potential output of the
economy. In most cases, this is a shift outwards as
the potential output of the economy increases.

As the LRAS shifts to the right, the real GDP of the

economy rises from Y to Y1 and the average price
level falls from P to P1.

Diagram 3.12 shows a shift in the LRAS curve to the right in response to an improvement in the
productive capacity of the economy.
Long-run aggregate supply can shift outwards if there is an:

1. Increase in the number of workers in the labour force because of migration.

2. Improvement in the skill level of the labour force because education and
training increase labour productivity.
3. Increase in capital available in the economy because of new investment.
4. Improvement in production technology such as the use of artificial
intelligence and robot technology on production lines.
5. Increase in the availability of a new natural resource such as the discovery
of oil and gas.
6. Improvement in the output from existing natural resources resulting from
technological improvement such as the use of genetically modified crops.

The long-run aggregate supply curve can fall if the potential output of
the economy goes down. This could have occurred if there was a war or
a natural disaster where capital is destroyed.
 Keynesian aggregate supply curve
The Keynesian aggregate supply curve was
developed by the economist, John Maynard
Keynes.

In the Keynesian theory, there is a single

aggregate supply curve and it does not distinguish
between time frames.

The shape of the curve show three possible

phases and does not distinguish between the
short-run and the long-run.
Phases of the Keynesian
aggregate supply curve
 Phase 1
When output is below Y in diagram 3.13, the economy has spare capacity and output can
increase and decrease without any change in the price level.

Below Y the economy has a deflationary gap and is operating below the full employment
level of national income.

In this situation the economy would have high unemployment and capital would be
under-utilised.
Phase 2
From Y to Y1 in diagram 3.13, the economy is approaching full employment and some
industries are nearing full capacity.

In this section, any change in aggregate demand will lead to a change in output and the
average price level. If aggregate demand rises, real GDP will increase and so will the
average price level.

Rising demand in the economy on this section of the Keynesian aggregate supply
curve will mean some industries nearing full capacity will experience price increases
and this will increase the average price level in the whole economy.
 Phase 3
When the economy is at Y2 it has reached full employment. There is no spare
productive capacity and the economy has very low levels of unemployment.

The economic conditions in this phase of the aggregate supply curve are typical of an
inflationary gap.

When aggregate demand changes real output does not change but the price level
does. If aggregate demand increases at Y2 there will be a significant increase in the
average price level and a rise in inflation.
 What will shift the AS and LRAS curves?
As country's factors of production are constantly changing, we would expect to see
steady increases in its AS/LRAS.

An OUTWARD shift of the curve means that its productive potential has increased.
Also it can be linked to an outward shift of the PPC.

The AS/LRAS curve will shift to the RIGHT if

there is an improvement in the quality of the
factors of production, which is an increase in
the productivity of the resources used in the
production.
What level of output in the economy represents
long-run equilibrium?

Difference between the
Keynesian and
Neo-Classical view
One of the key issues that arise from the
Keynesian aggregate supply curve is that
the economy cannot self-correct when
there is a deflationary gap. This is the key
difference between Keynesian and the
Neo-classical/Monetarist aggregate
supply model.
Keynes argued that wages and costs do not fall
when there is a deflationary gap because of
minimum wage legislation, trade union activity
and firms would prefer to cut jobs rather than
wages in a recession. Keynesian economists say
wages are ‘sticky downwards’ because these
pressures stop wages from falling when aggregate
demand decreases in a deflationary gap situation.
This means the economy cannot self-correct as it
does in the Neo-classical/Monetarist model
where wages and costs fall causing the short-run
aggregate supply to increase and the equilibrium
income to return to full employment.